PSNC 2011: Alpha “Bets”

Steven W. Glasgow, SVP, Avondale Partners LLC, says the response he almost always gets from clients when asked if they have considered LDI is that they are waiting for interest rates to go up. The thinking is that interest rates are down now and can only go up, so a move to fixed income now could mean losing ground in the future.  

But, Glasgow said it is a mistake to think in terms of asset returns; sponsors must focus on limiting funding status volatility. While he admits that those hit hard by the recent recession whose pension funded status is low need returns to increase to overcome fixed liability payments, as funding increases, sponsors should shift to minimizing funding costs over the life of the plan.  

He contends that plans that do so stay near 100% funded, while others stay below 100% funded and may even get worse.  

John Dixon, Manager, Employee Benefits, Joy Global Inc., whose firm is in the process of moving to LDI, agrees that a key barrier in deciding to take that approach is making the leap that asset return is a distant second to benchmarking liabilities. It is a complete change in focus, and it is hard to get managers on board.  

For pension plan sponsors considering the current low interest rate environment, Dixon suggests rethinking what they are trying to accomplish. “Yes, they are low and as they rise, it will hurt fixed income returns, but you’re trying to match liabilities,” he said.  

Another barrier is the realization that while moving the plan’s investment portfolio to more fixed income, returns will drop, increasing the cost of the plan and requiring more cash contributions. Again, Dixon says it goes back to changing focus.  

To start the process of managing funded status volatility, Francis A. Salem, Sr. Portfolio Manager, Columbia Management, says to start with liability in the analysis of how to invest going forward. Sponsors should look for a return that compares with the change in the value of liabilities every year, with lowest risk. Begin with duration matched fixed income, bonds put together to match the annual liability discount rate, Salem suggests.   

The next part in the process is to look at expected return and expected risk of different asset classes relative to liability. Sponsors are moving to less risk to decrease volatility in funded status.  

Salem says typically sponsors put together a glidepath that will move to 100% duration matched fixed income as the funding status moves to 100%. According to Salem, now is a good time to use an overlay program, in which the sponsors takes 50% of the fixed income portfolio and extend duration so it covers 70% of liability.  

Salem also says hedge funds are a good source of alpha with lower volatility of returns than the S&P and higher returns than fixed income. They help to match liability while producing more returns.  

Dixon said his organization is ramping up fixed income into a long duration portfolio, and along with aggressive funding the pension fund is about to hit a 70% fixed income allocation. Once it hits 70%, the firm will take a glide path approach to match funded status improvements. 

Joy Global will be working with two managers, one an expert in building duration match (called the completion manager), and another expert in securities selection. The plan will have a large portfolio with the firm that does securities selection, then the completion manager will fill the gaps and build a duration matched portfolio.