The 2020 funded status of the 100 largest corporate defined benefit (DB) plans by assets rose only slightly as double-digit equity returns were offset by a decline to record-low discount rates, according to a proprietary analysis conducted by J.P. Morgan Asset Management.
The report, written by Michael Buchenholz, head of U.S. pension strategy, institutional strategy and analytics, reveals the benefits that came from rebalancing liability-driven investing (LDI) portfolios during the market volatility of last year. He first points out that for plan sponsors to have meaningfully rebalanced into risk, they would have needed a two-way glide path permitting re-risking or an investment team with wide discretion; the ability to quickly raise liquidity, in the portfolio or from the sponsor; and the capacity and ability to conduct transactions on short notice.
To illustrate the potential benefits of reallocating, J.P. Morgan took a simple 50%/50% LDI portfolio and estimated returns under different rebalancing policies. Without any rebalancing, the sample portfolio—50% MSCI All Country World Index (ACWI), 40% U.S. long credit and 10% U.S. long Treasuries—earned 15.2%, a bit better than the top 100 plans’ average return of 14.2%. Rebalancing monthly back to target allocations earned an additional 80 basis points (bps), while rebalancing just once at March 31 earned an additional 225 bps.
Buchenholz notes that hedge portfolios are still the focal point of most LDI strategies, but he suggests that corporate DB plans might have put up an illusory line of defense with corporate credit.
“One of the most pernicious adversaries of hedge portfolio effectiveness is credit defaults and downgrades, generating fixed income losses and liability increases as higher yielding bonds exit the pension discount curve universe,” the report says. “Corporate bond hedges become … sources of vulnerability.”
However, in late March, the Federal Reserve’s announcement of policy measures, including primary and secondary market corporate bond-buying programs, helped drive long corporate spreads down from a peak of 360 bps on March 23 to about 230 bps by the end of April. Buchenholz says these downgrades, in addition to leniency from credit agencies, might be keeping liability valuations artificially depressed. He adds that the proprietary analysis found less than 10% of fixed income portfolios are allocated away from traditional investment grade credit and Treasurys to hedge diversifiers such as mortgage loans, securitized assets and emerging market debt.
The report notes that employer contributions into DB plans surged in the fourth quarter of 2020. Buchenholz says it’s understandable that DB plan sponsors waited for economic conditions to stabilize before committing mostly voluntary contributions to their plans, but cash infusions tend to be most valuable during periods of economic stress. J.P. Morgan examined contribution scenarios with varied timing and fund allocation and found that the best opportunities were contributing to fund equities in March. This would have returned almost 50% or cost roughly 68 cents to buy a dollar of end-of-year assets.
Taking the lessons from the past year, J.P. Morgan recommends that re-evaluating glide path triggers and bands while permitting re-risking can set plans up to take advantage of future market dislocations.
The firm also suggests that corporate DB plans fortify their hedges with diversified exposures such as securitized assets.
In addition, DB plans should consider alternative assets. “As expected returns have continued to fall, alternative asset classes have an increasingly important role to play in generating returns, diversification and income. By taking stock of intermediate-term liquidity needs like benefit payments and potential risk transfer transactions, corporate pension plans can better understand their tolerance for illiquid assets in the portfolio,” the report says.
The full report may be downloaded from here.
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