Refining Your LDI Strategy in a Low Return Environment

“It’s certainly an interesting time to take a step back and look at where we are, where we've been, and most importantly, what we expect from markets on a go-forward basis,” said Jessica Hart, Practice Lead of Retirement Assets Multi-Manager Solutions at Northern Trust Asset Management, speaking at Pensions & Investments’ virtual conference series ‘The Evolution of OCIO.’ “This is a difficult investing environment … and the OCIO model allows plan sponsors to leverage professional teams who work full time on increasingly complex investment portfolios, and often implemented with a lower cost structure,” she added.

At the session titled ‘The New Normal for Investment Returns and Allocations,’ Hart highlights some key themes from the firm’s 2021 Capital Market Assumptions, which is a five-year outlook on the drivers of the markets on a go-forward basis with expected returns for various asset classes.

• ‘Retooling Global Growth’ reflects a view that companies will begin to prioritize stability over profitability by retooling supply chains, bringing production back to home countries, and building stronger balance sheets. The net result is a lower expected economic growth rate, which certainly will have an impact on equity market expectations, Hart said.

• ‘Massive Monetary Tool Kit’ reflects a view that while some market participants have worried that central banks didn’t have the tools to combat the next recession, we’ve actually seen that central banks in coordination with fiscal policy have been able to mitigate the impact of the recession through the purchase of securities, Hart said. That support will continue, and we think rates are going to continue to stay at extremely low levels, she added.

• ‘Stuckflation Tested’, is a modification of the stuckflation theme that has been in the Capital Market Assumptions since 2016. The previous version refers to our view that inflation will remain at very low levels, and certainly below 2% in the U.S., Hart said. This year’s “Stuckflation Tested” theme is a slight modification, recognizing that with trillions of dollars flowing into the economy, there may be inflationary pressures in the marketplace, testing stuckflation—but our base case remains that continued low inflation will likely prevail since it will take many years for those inflationary pressures to manifest, she said.

"Given those themes, what does that mean for expected returns?" Hart asked. “Within the equity market, higher valuations, slow global growth, and lower profitability will likely result in more subdued returns. Our equity expectation for global markets is at 4.9% over the five-year period. Within the fixed income market, we foresee rates to stay very low, with short rates at zero and long rates staying low, given the lack of inflation,” she said, adding “In this environment, we see opportunities in credit, particularly in high-yield credit and real assets. There's pressure around real estate, no question, which we can discuss. We think infrastructure is a potentially interesting area and may ultimately be the winner in the real assets space over the five-year period.”

When considering alternatives, manager selection is critical, Hart noted. “The ability to research, perform due diligence and access top talent is critical. We've all seen the average return numbers. Quite often, they're not overly compelling, so really making sure you're able to access the right opportunities makes this all come together.”

Given these capital market assumptions and impact on portfolio returns, there are a variety of implications for defined benefit plans, including an impact on time horizon and the ability to take on more illiquidity, Hart said. "It doesn't have to be 15-year lock-up, but given a lot of plans are going to see a longer time horizon as a result of the return environment, there may be more of an opportunity than they've historically seen to consider semi-illiquid investment options and earn higher return as a result,” she said.

The environment also has implications for the construction and implementation of liability-driven portfolios. Plan sponsors may consider using overlays to build a more capital-efficient LDI portfolio, and also consider whether to hedge across the yield curve which has been done previously, she said. In addition, based on the capital market assumptions, the risk premium between equity and long credit has come down, Hart said. “So for a plan that is relatively better funded and has a decent long credit exposure, is the 40 or 50 basis points of incremental return from equity worth the additional funded ratio volatility?”

“We still believe, even where rates are, that the LDI approach is appropriate for a pension plan, particularly one closer to a fully-funded level. We don't see rates helping from a funded ratio perspective, certainly in our forecastable period,” Hart said. When sponsors now consider the role of government bonds, “will they be the safe haven they have been in the past? For clients further along their glide path, we've actually pulled down some government exposure in favor of credit. That's been a good trade more recently, as credit spreads have contracted.”

Another tactic has been to increasingly use overlays for that government exposure, Hart said. “For a more capital-efficient strategy, we don't need to put all that capital at work to buy government bonds that are yielding very little. Let's get that same exposure through the futures market and free-up additional capital that we can then redeploy, whether it's in credit or someplace else.”

For DB plans that have established glide paths and have trigger points at various funded ratios, “it's certainly worth reconsidering those trigger points and how far apart they are,” Hart said. “You may want to put them closer together in order to take advantage of continued volatility. If you're further along on that glide path, you want to try to take advantage of these incremental moves, putting your trigger points closer together to try to lock returns in over time.”

“What keeps me up at night? The reality is, and we’ve all been there, it’s the risk I can't predict,” Hart said. “We certainly saw that this year. At this time last year, not many folks would have expected the world to look as it does today. The only way to protect against unforeseen circumstances is some of the things we've talked about: diversify your return sources, approach risk prudently, and stay true to your long-term strategy because there are always going to be things that we do not foresee, that the risk models do not foresee.”

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