Defined benefit (DB) plan sponsors took an unexpected hit when the market crashed because of the COVID-19 pandemic, and many found past strategies they used in bear markets needed to be tweaked for the unprecedented volatility that followed.
The volatility is likely to continue for an unknown amount of time, and some financial professionals are speculating about whether and when another market fall is likely. An Insights article from Willis Towers Watson suggests institutional investors should adopt the right strategy, investment approach and governance structure for a permanently changed environment rather than building a framework that depends on waiting for a recovery. “Rather, the aim should be to be well-positioned to deal with a continued period of uncertainty, whether this is directly related to the current pandemic or something that is as yet unforeseen,” the article concludes.
“We do think there will be a lot of uncertainty from here given that there are several different paths the economy can take,” says Jon Pliner, senior director, investments and U.S. head of delegated portfolio management, Willis Towers Watson in New York City. He adds that DB plan sponsors need to manage risk at a total portfolio level.
“When they think of LDI [liability-driven investing], it’s not just segments, but how the portfolio will move with respect to liabilities as a whole,” he says. “With a traditional liability-hedging portfolio, sponsors are looking to manage interest rate exposure, but they also want assets to protect the portfolio overall.”
A New Direction
Al Pierce, managing director at SEI Institutional in Oaks, Pennsylvania, now based in his sleeping porch at his home in Swarthmore, Pennsylvania, says the first thing SEI does with clients to ground the discussion about DB plan risk and asset allocation is discuss what is happening at the sponsor company itself—balance sheets, cash flows and profit and loss (P&L) forecasts can be volatile as well. Plan sponsors’ strategies or policies, as well as LDI glide paths, may have been interrupted.
Answers to questions were more straightforward before the current market environment, but now plan sponsors need to think about taking new directions.
Regarding overall asset allocations, plan sponsors need to ask whether they are in appropriate asset classes, Pierce says. When moving to re-risk—increasing return enhancement or non-LDI assets—the components would depend on funded status. For example, clients that are well-funded would invest in low volatility equities, have limits around emerging markets and have alternative low-beta or non-directional hedge funds. “It’s now less about which asset class will outperform another and more about the risk return profile needed to accomplish the goal for the plan,” he says.
Plan sponsors also need to ask whether their LDI glide path is appropriate, what the risk associated with re-risking is and if they feel comfortable taking that on, Pierce says. Corporate bond spreads have been very volatile because of the COVID-19 pandemic. He notes that the same thing happened during the 2008-2009 financial crisis, but anyone using swaps or Treasuries then outperformed. Now, rates have not moved.
“If a plan sponsor uses an LDI glide path and was 90% funded, it may have had 40% of assets in LDI vehicles. But, now it may be 85% funded. The first question should be how is it going to move along the glide path given the volatile situation now. It may need to stay on its glide path but, if so, expected outcomes will be different—expectations for return and the yield path are different than when the glide path was set. It likely should reduce assets in LDI vehicles,” Pierce explains.
Plan sponsors also may be asking whether they should put money into their DB plans to keep them on the glide path. Pierce says most sponsors that were making discretionary contributions to the plans decided they needed to back off because of uncertainty for their business and the cost of capital. “They need cash for things other than the plan,” Pierce says.
He adds that it is uncertain what the next three to five years will look like for required contributions to plans as well. “2019 was unusual in that asset growth was strong and the calculation of liabilities was strong. This year, discount rates used to measure liabilities are flat and asset values are down. This will impact required contributions,” Pierce says.
While not a new idea, Mike Moran, senior pension strategist at Goldman Sachs Asset Management in New York City, says when DB plan sponsors consider higher funding deficits and higher Pension Benefit Guaranty Corporation (PBGC) variable rate premiums, now may be a time to think about borrowing to fund. “We saw that a lot several years ago, and in the past couple of weeks more clients are thinking about it as deficits have widened,” he says. If they can borrow at attractive rates and contribute the proceeds to their pension plan, they can reduce—or even eliminate—their pension deficit.
Pierce says clients have been discussing their pension risk transfer (PRT) strategies. Due to the dilutive impact of PRT’s when plans are less than fully funded, along with the desire of many plan sponsors to conserve cash and minimize pension contributions, we would expect PRT activity to be low.
He adds that he hasn’t yet seen insurance carriers adjust their underwriting in recognition of the fact that mortality expectations may be higher due to the coronavirus than what they priced in six months ago. “What impact would that have on annuity pricing, and should plan sponsors wait?” Pierce questions.
With volatility here to stay, a new risk factor Kevin McLaughlin, head of liability risk management at Insight Investment in New York City, says plan sponsors need to give more attention to is liquidity. “We had a liquidity freeze in March. Many clients in are in the decumulating phase for their DB plans and they need more liquidity. They need a liquidity buffer going forward,” he says.
All these questions about strategy mean plan sponsors need to ensure they have the proper governance in place and that they can evolve as they need to, Pliner says. “It is important to be able to make quick decisions about the LDI path and to have a framework to take risk off and lower return assumptions but manage risk on an ongoing basis,” he says. “Adjustments to portfolios—undoing de-risking or changing triggers on an LDI glide path, for example—should make sense in the market environment that exist at that point in time.” Pliner says plan sponsors should look both internally and externally to build a governance structure that can make good decisions and take advantage of opportunities when they arise.
Moran says it’s a challenge to be flexible if there is not an internal dedicated team for the plan. Decisionmakers may meet quarterly or may have a one-off meeting sometimes, and they may not even have real-time information to make decisions. “They may need hands on the plan every day now,” he says.
Pierce notes that SEI is an outsourced chief investment officer (OCIO) for its clients. Plan sponsors have to focus on business challenges and want time spent on DB plans to be productive. The value in having an OCIO, he says, is decisions can be more impactful, rather than just determining whether to get rid of an investment or investment manager.
“Plan sponsors’ strategies should be reviewed in light of how their business forecast has changed and the drivers of that—they go hand-in-hand; a pension plan is part of a sponsor’s capital structure. Reflect on how things should be adjusted and what can be done in an environment that will be different for the foreseeable future,” Pierce says. “I am confident that anything in place on January 1 is probably not effective or the right answer given where their business is now.”
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