The volatile equity market, an expectation of lower future returns and the low interest rate environment have led many financial professionals to suggest the traditional 60/40 portfolio is no longer effective for retirement plans.
With their minds on improving the funded status of their plans, many defined benefit (DB) plan sponsors take the traditional 60/40 portfolio a step further and use liability-driven investing (LDI) strategies. Considering those market factors, are traditional LDI strategies no longer effective?
Michael Clark, managing director and consulting actuary with River and Mercantile, says last year was an interesting year in terms of what it showed about what DB plan sponsors do with LDI glide paths in volatile markets.
“Most plans probably ended the year where they started [in terms of funded status], but there were a lot of ups and down in between. Those that rode the course probably ended the year slightly worse off,” he says. “After the market crash in the first quarter, those that put more money into growth assets probably are a little ahead of those that stuck with the status quo.”
Most DB plan sponsors are looking for a portfolio strategy that prevents them from going backward in funded status, Clark says. There is a trade-off between liability hedging and seeking returns. “Plan sponsors need an understanding of what risks they are taking on and where and how that should change over time to get them to where they want to be,” he says.
The broad thesis is that DB plan sponsors do need to think about restructuring their LDI portfolios, says Kevin McLaughlin, head of liability risk management, North America, at Insight Investment. He says plan sponsors should focus on two things: increasing the hedge ratio due to extreme volatility to make sure they have enough liquidity, and increasing returns to fill funding gaps.
More than ever, plan sponsors need a hedge for liabilities, McLaughlin says. “If they don’t hedge for interest rates and get it wrong, even small movements in interest rates will mean the return needed from growth assets will increase exponentially,” he explains. “Plan sponsors need to do more hedging now than in the past, particularly if they are underfunded.”
McLaughlin adds that plan sponsors need to hedge to control volatility. “We advise clients to try to keep problems solvable through investment returns. If interest rates decline, they will need assets to fill the funding gap,” he says. “The reason we think underfunded plans need hedging is we’re not sure we’ve seen the bottom for interest rates and there is so much market volatility.”
Components of an LDI Portfolio
Going beyond the traditional glide path, Clark suggests DB plans can use derivatives to decouple risk from growth. A derivative is a security with a price that is dependent on or derived from one or more underlying assets, according to Investopedia. Underlying assets could be stocks, bonds, commodities, currencies, interest rates or market indexes. The derivative is a contract between two or more parties based on the underlying assets, and its value is determined by fluctuations in the underlying assets. Futures, swaps and options are types of derivatives.
“With derivatives, plan sponsors can decide how much interest rate risk to take on or hedge and how much market risk to take on or not, and they can do that in a very controlled way,” Clark says. One way to do that with derivatives is by taking the assets in the portfolio and investing all of them in liability-matching vehicles, then accessing equity synthetically through puts, calls and options strategies to give equity a value the plan sponsor is comfortable with, he explains.
“This offers an optimized interest rate hedge and an equity exposure plan sponsors are comfortable with,” Clark says. “Sponsors get some downside protection, a range of returns they like and a bigger engine than what they have with just the physical assets in the portfolio.”
Clark says derivatives swap options (also known as swaptions) should be considered for the liability-matching side of LDI portfolios. “We’ve been talking to clients about the potential for interest rates to go up and liabilities to go down, but they don’t necessarily want to lock into a strategy,” he says. “This is where derivatives swaptions can be adjusted to protect the plan when rates fall.”
According to the Corporate Finance Institute, a swaption is an option contract that grants its holder the right, but not the obligation, to enter into a predetermined swap contract. In return for the right, the holder of the swaption must pay a premium to the issuer of the contract. Swaptions typically provide the rights to enter into interest rate swaps, but swaptions with other types of swaps can also be created.
“When you look at pension plan risk management in general, most DB plan portfolios have liability-matching and return-seeking assets, and they use funded status triggers to make portfolio changes. We’ve seen that’s effective to a point,” Clark says. “But for plan sponsors that want to make a meaningful difference in closing their funding gap, they need to look at different tools. Derivatives present good opportunities, especially in volatile markets like we’ve seen in the last 12 months.”
McLaughlin also points out that many plans are cash flow negative—paying more in outflows than they get in inflows. For this reason, they want to avoid a large shock to assets, especially large declines or drawdowns. “There’s a lot of focus now on the equity downside,” he says. “We see more focus on low volatility equities or volatility-control type strategies. There is much more interest in downside equity protection; there’s been a move from diversification to downside protection.”
For the growth part of an LDI portfolio, being well-diversified is still important, Clark says. “We saw quite a bit of disparity in asset classes in 2020,” he says. “Plan sponsors should understand what asset classes are available to them to create a well-diversified portfolio, and rebalancing is a tried and true principal.”
On the fixed income side of an LDI portfolio, there’s been interest in how to increase returns from fixed income assets, McLaughlin says. “We’ve seen more interest in private markets and illiquid securities such as structured credit and private loans,” he says. “The challenge is that more illiquid assets could potentially mean not enough liquidity to pay for outflows, which would make DB plan sponsors become forced sellers of equities. So they need to be careful when changing portfolio components on the fixed income side.”
McLaughlin says he has seen plan sponsors solve this conundrum by having more liquidity on the equity side of the LDI portfolio. Plan sponsors may do so synthetically via equity futures or equity return swaps.
“We would say two things: When hedging DB plan portfolios, be as capital efficient as you can to free up assets to pay benefits or buy private credit, and protect against large drawdowns in equity by having a strong hedge ratio to protect from volatility,” McLaughlin says.
Rethinking Glide Path Triggers
McLaughlin suggests DB plan sponsors should rethink their LDI portfolio glide path triggers. “Many [plan sponsors] are in a situation where they are a long way from the next glide path trigger on a funded status basis or on a market level basis—for example, a trigger of a 3% market rate on Treasurys,” he says. “A big focus in 2021 will be reassessing glide path triggers to make sure they are realistic.”
McLaughlin says Insight Investment’s broad advice would be for plan sponsors to have both a funded level trigger and an interest rate trigger. “Plan sponsors have to consider what could happen if equity markets decline and funded status declines. It’s better to have a combination of triggers so as not to miss hedging opportunities,” he says.
Interest rate triggers will signal a path for hedging, McLaughlin explains. “If interest rates go up by a certain amount of basis points, the plan sponsors can do more hedging,” he says. “If the interest rate trigger is less static and more dynamic—if plan sponsors think interest rates are range bound—there is more flexibility. Plan sponsors can take hedges off and on.” McLaughlin says he’s seen this strategy used a lot in the UK and he believes U.S. plan sponsors can take advantage of it.
Plan sponsors that adjusted their portfolios when they hit a funded-status trigger but fell below it due to a market downfall last year should look to their investment policy statement (IPS) for what to do, Clark says. It might require them to re-risk their portfolios. “Many who did that in the first quarter of 2020 came out ahead by the end of the year,” he says.
Clark says River and Mercantile would advise that, in light of 2020, which showed that market movements can happen quickly, plan sponsors should look at their governance structure. “If the IPS and governance structure don’t allow [plan sponsors] to take advantage of market movements quickly, they will miss out on market opportunities,” he says. “Having good consultants watching for opportunities and bringing ideas to the table while being able to act quickly will be key to making progress on funded status.”
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