Providers that work with defined benefit (DB) plans are expecting a period of prolonged volatility caused by the COVID-19 pandemic.
DB plan sponsors put a lot of effort into addressing two factors when investing: managing interest rate risk and generating returns to improve funded status. What strategies should plan sponsors consider for reaching their goals in the new market environment?
Addressing Interest Rate Risk
A Willis Towers Watson Insights article suggests that a well-designed interest rate hedging strategy “can protect against the plausible scenario under which interest rates fall (and bonds become more expensive) into unprecedented territory, and remain there for a long time.” Jon Pliner, senior director, investments and U.S. head of delegated portfolio management, Willis Towers Watson in New York City, says there is still a lot of risk interest rates could fall and, with actions the Fed is taking in this economy, “we are not likely to see an increase in interest rates.”
Mike Moran, senior pension strategist at Goldman Sachs Asset Management in New York City, says that following the market volatility in March and April, clients are thinking about hedging their liabilities. He notes that long government bonds have worked well for DB plan sponsors as they move along their liability-driven investing (LDI) glide path, but with rates falling so much now, clients are wondering whether to shift to credit investments. “We would highlight intermediate credit as a place to look,” Moran says.
In commentary, Tom Meyers, executive director and head of Americas client solutions for Aviva Investors in Chicago, notes that in 2009, LDI investors were rewarded for tactically allocating away from Treasuries into corporate bonds and Aviva is seeing action in that direction right now. “Similar to the post financial crisis environment, an exposure to Treasuries successfully played its part in mitigating volatility. Now might be the appropriate time to, once again, increase long credit allocations for corporate DB plans,” he says.
Meyers notes that a review of the U.S. Long Credit Index over the past roughly 50 years has shown considerable reward for allocating to U.S. long credit following episodes of dramatic price declines.
Kevin McLaughlin, head of liability risk management at Insight Investment in New York City, says his firm considers two ways to address low interest rates. He explains that DB plan sponsors can set a “floor” at which the portfolio is protected if rates drop lower. “Rather than hedging at current low levels, have a floor and be able to lift off hedges as rates rise,” McLaughlin says.
“Many plans have funded status triggers at which time they buy more fixed income,” he continues. “They may need to think beyond funded status triggers and use market-based triggers as well.” So, if Treasuries reach a certain level, plan sponsors can consider increasing their hedge. McLaughlin adds that it should not be an all-or-nothing decision when to hedge—consider what a plan sponsor would do if interest rates rise then subsequently fall back.
“If plan sponsors review their triggers, they’ll find the likelihood of reaching them is lower. Also, interest rates used in funding calculations are range-bound right now, so they need to think about how to manage triggers in that context. Sell hedges when rates are high and buy them when they are low,” McLaughlin says.
Moran says clients are also thinking about generating returns to cover benefit accruals and make up for increased deficits following the market fall. But how can a DB plan portfolio generate returns when bond yields are so low? He says while DB plan sponsors have had a 10% nominal return target, they need to think about how to get to 6% or 7%. They should consider alternative asset classes again, the opportunity in private markets and, where there has been a move to passive strategies, now is a good time to think of active strategies again.
Pliner says diversification is important because it is unknown which way the market will move. “Don’t just buy equities but a diverse range of assets with different return patterns in different economic environments,” he says.
DB plan sponsors should add protection strategies where they make sense, Pliner adds. “Options became sensitive as volatility spiked, so they may not be attractive. Plan sponsors should look for attractive opportunities to hedge out risks. Investments with low beta and convex return structures may do well when the rest of the portfolio is not,” he explains.
If a DB plan portfolio moved more into fixed income based on a funded status trigger right before the market crash, Moran says sponsors should consider rebalancing. “We don’t consider that re-risking, just getting back to strategic targets.”
However, he suggests plan sponsors don’t just rebalance tactically, but move more into equity, which is re-risking. “Should [plan sponsors] re-risk as funded status falls? For the majority of our clients, the glide path is a one-way street, but they should consider what else is going on with the plan,” Moran says. “For example, if the plan is closed or frozen and large, re-risking doesn’t make sense. But for smaller plans or those with new benefits accruing, if they have the capacity to take on more volatility, they should consider re-risking.”
Private market investments have been an increasingly popular place for DB plan sponsors to go to generate returns, and, Moran says, they still are for those plans that are open and accruing benefits. He cautions those plan sponsors with a goal of getting out of the DB business to not sign up for one with a 10- to 15-year life. He adds that he’s also had more conversations lately about hedge funds than he has in the past few years. “It’s a matter of working on the right playbook in this market. Look at some asset classes you haven’t invested in recently or never have,” Moran says.
Hedge funds are used for protection on the equity side. But, in the past couple of years, as plan sponsors developed their equity risk mitigation strategies, they have been trying to shrink the distribution of outcomes, Moran says. Plans may consider lower beta stocks, higher dividend paying stocks, more options-based strategies and interacting in a more systematic way with public equity holdings.
McLaughlin says his advice is to consider tail risk hedges. Tail risk is an extreme shock to financial markets that shows up as infrequent observations in the far left tail of a return distribution. It is technically defined as an investment that moves more than three standard deviations from the mean of a normal distribution of investment returns.
Tail risk hedging was a great concern following the 2008-2009 financial crisis. Institutional investors surveyed in 2012 noted the following as effective hedges against tail risk, ranked most to least effective: diversification across traditional asset classes, risk-budgeting techniques, managed volatility equity strategies, direct hedging-buying puts/straight guarantee, other alternative allocation (e.g. property, commodities), managed futures/commodity trading adviser (CTA) allocation, single strategy hedge fund allocation and fund of hedge fund allocation.
But, McLaughlin says, DB plan sponsors can still use fixed income, even though yields are lower, to generate returns. He says they should consider structured credit assets, which provide higher returns but not necessarily higher risk. “Think beyond corporate bonds and Treasuries to more securitized assets.”
“This is time when [plan sponsors] need to apply good judgment more than anything else,” McLaughlin adds. “Long-term, we think the consequences of being in a bigger macro cycle are more profound. We expect to see more episodic volatility, and we don’t have enough data now to react with sufficient confidence. At least in the short term, sponsors should rely on their best judgement. We are not advising wholesale changes. Plan sponsors should stay the course but give thought to what increased volatility means and pay attention to liquidity, and wait for data to come in. We need more clarity before we can be more aggressive.”
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