IT’S ALL ABOUT DERISKING
Pension Risk Management Webinar
One word neatly sums up the state of corporate defined benefit pension plans — derisking. Plan sponsors, with significant help from their investment managers, are focusing on minimizing risks and maximizing their capacity to pay out liabilities.
Driving this trend is the fact that many pensions are not only closed or frozen, but also overfunded. The Milliman 100 Pension Funding Index, which measures the funded status of the largest U.S. corporate plans, currently stands at 103.6%.1 Until recently, plans hadn’t been overfunded since 2007, just before the great financial crisis.
According to Timothy Quagliarello, senior vice president and client advisor at Franklin Templeton’s U.S. institutional business, “There’s been considerable derisking activity over the last two years due to the rapid improvement in funded status for a majority of U.S. pension plans as a result of higher bond yields.”
Coalition Greenwich’s 2023 Corporate Defined Benefit LDI Study underscores the importance of derisking. Nearly all survey respondents — 96% — cited risk management as the top quality they seek when selecting a liability-driven investment manager. Along with fees, their No. 2 quality was “knowledge/understanding of key pension risk elements.” (See visual on top qualities in selecting LDI managers.)
For many plan sponsors, particularly if their plan is frozen, investment strategy changes when the plan is fully funded. Achieving outsized returns in excess of plan liabilities becomes less desirable while protecting the gains in funded status and finding ways to shrink liabilities over time become more of a priority.
Not derisking poses significant challenges beyond reducing a company’s ability to pay its retirees, Quagliarello added. “There can be notable consequences for the corporation if the pension falls back into underfunded territory, including higher Pension Benefit Guaranty Corporation premiums, potentially large corporate contributions and greater balance-sheet volatility,” he said.
Start with LDI
How are plans derisking? There are multiple ways to do it.
The most straightforward approach is liability-driven investing, which uses fixed income to match the durations of plan liabilities. LDI strategies were challenged during the era of lower-for-longer interest rates, but they are in much better shape for achieving target outcomes since the Federal Reserve started raising rates in early 2022.
“Plans are focused on what their strategy should be, and in many cases, it’s to more fully hedge their liabilities. For various reasons, they weren’t able to bring themselves to do that when rates were low,” said Andy Hunt, CFA, FIA, senior investment strategist at Allspring Global Investments. “People are extending their duration and trying to get their hedge ratio from 30-40-50%, where it used to be, up to 70-80-90%. We’ve been talking to a number of clients who resisted buying duration when yields were low, but now that they realize that that doesn’t apply anymore, they want to buy more long-duration assets at today’s yields.” (See visual on taxonomy of long credit strategies for LDI.)
But adding long duration these days is complicated because the Treasury and corporate yield curves are flat to inverted — with similar or lower yields on longer-dated bonds versus short-term bonds — instead of traditionally steep.
Hunt generally recommends long maturities to match liability duration, but he also sees intermediate maturities as attractive, given the flat-to-inverted curve. “If you want to add to your LDI portfolio, should you be adding at the 10-year point or at the 30-year point?” he asked. “My answer is that both are needed over time, but the credit-spread differential between the 10-year corporate bond and the 30-year is historically very tight, meaning that very long corporate bonds have gotten quite expensive versus intermediate corporates. And so intermediate could be a good tactical move versus adding long at the moment.”
Read: The Risk Report
Adjust the manager lineup
Another derisking strategy involves reconfiguring a plan’s lineup of investment managers. When plans hit a glidepath trigger, it prompts an increase in their bond allocation. In some instances, they’ll add a new manager in the name of diversification, said Tom Meyers, CFA, senior director of investments and strategy development at Franklin Templeton.
Sponsors review their LDI manager lineup when their plans become fully funded. Seventy percent of sponsor respondents to Coalition Greenwich’s Corporate Defined Benefit LDI Study, for example, said that they review their manager choices following funding gains to ensure they can achieve their plan’s goals.
Meyers said that sponsors of highly or fully funded plans often realize that they had hired most of the managers when their funded status was lower. “Investment objectives at that time are different than the objectives when you’re fully funded,” he explained. “Plans have paired high-beta, high-alpha-seeking managers to generate growth, but they’re not getting true diversification of exposures. Instead, they can expose plans to downside risks, particularly when spreads widen or if there’s a dislocation in credit markets.”
Meyers recommends not only removing manager overlap, but also adding managers that can produce positive returns regardless of the direction of credit spreads. This offers better diversification and can protect portfolios in periods of market stress.
Watch out for illiquids
When pensions are less than fully funded, they use a variety of strategies to generate growth that will support future liability payouts. Alternative assets have been effective growth generators in this context by providing attractive returns, low volatility via less-frequent market pricing and diversification of traditional long-only assets.
The trade-off, of course, is that alternatives are illiquid — which poses a big challenge for fully funded plans that need liquidity to increase their bond holdings or pay liabilities. Allocating too much to illiquid assets in the last few years has caused rebalancing and liquidity issues with potentially negative consequences.
Meyers urges sponsors to be thoughtful about taking illiquid exposure as their funded ratios rise. “You have to be careful about your liquidity exposure when you’re fully funded,” he said. “It’s important to offset liability risk more closely via liquid bonds. To do that, you need to have enough liquidity to sufficiently allocate to those bonds and to reduce your funded-status volatility in the process.”
“Plan allocations have gotten out of balance over the last several years because the value of fixed-income and public-market assets has fallen while the value of illiquid asset classes has been pretty stable,” Meyers added. “You end up being overallocated to illiquids and can’t easily get access to that money when you need to further derisk or pay benefits.”
Source: Coalition Greenwich 2023 Corporate Defined Benefit LDI Study.
Offload risk to insurers
While some pension plans are enhancing their LDI strategy to boost derisking, others are squarely focused on pension risk transfers. These transactions allow plans to purchase insurance coverage in order to transfer their liabilities to an insurance company which assumes the investment risk through an annuity contract. Some plans are pursuing buy-ins, where a group annuity purchase remains on the plan’s balance sheet; and others are focused on buyouts, where the group annuity purchase moves the liabilities off the balance sheet.
According to Allspring’s Hunt, plans are transferring about 2% of their liabilities annually, a level that he expects to remain fairly steady. Transferring not only reduces the amount of liabilities on a plan’s books, but it also can be a relatively cheap process, especially if the selected groups of plan beneficiaries are expensive to maintain.
“These small-balance liabilities tend to be the costliest to keep on your balance sheet compared to their value,” said Hunt. “Because they have proportionately the highest administrative and record-keeping costs, they’re the top candidates to remove from your plan. But they’re also the least consequential liabilities in terms of affecting the plan’s overall duration, aka risk.”
Source: Allspring Global Investments
Tackling PRT in stages
Large pension plans tend to implement risk transfers in stages. Keeping it small is easier not just for the plans, but also for the insurers taking on the risk.
“Full terminations are a heavy administrative and operational lift for plans,” said Franklin Templeton’s Quagliarello. “Our clients that pursue risk transfers typically want to cleave off small chunks of their retiree population and reduce the overall size of their obligations over time.”
Quagliarello explained that it can be more challenging for both sponsors and insurers to take on a full termination, especially when there are still active participants in the pension plan. Retirees are preferable because their payments are much more predictable and, therefore, easier and cheaper to annuitize. That’s why partial transfers account for the vast majority of activity among large plans, he said.
To prepare for a PRT, Quagliarello said, “it’s important for plans to lower their funded-status volatility, make sure to lock in those recent funded-status gains, minimize drawdowns and build high-quality portfolios of cash bonds that an insurer would eventually want to take on.”
DON’T FORGET EQUITIES
While much of the attention on pension management naturally focuses on fixed income, equities retain an important place in many portfolios, regardless of funded status. Asset managers caution that equities — equity volatility, more specifically — pose a significant risk to plans’ ability to meet their obligations.
“Pension managers need to be cognizant not just of the shifting dynamic between equity and fixed income, but also that equity itself is becoming much more volatile,” said Michael Hunstad, deputy chief investment officer and chief investment officer of global equities at Northern Trust Asset Management. (See visual on equity market volatility.)
Equities account for virtually all surplus volatility in pension portfolios, he pointed out. “Pension managers should care very much about surplus volatility because they want to keep their liabilities and assets as much in check as possible.”
A significant shift in what Hunstad calls the “microstructure” of equity markets should materially contribute to equity volatility going forward: Roughly half of institutional assets are passively managed, compared with only about 5% 20 years ago. For the remaining half of institutional assets, non-institutional (i.e., retail) investors exert much greater influence on price discovery than was previously the case.
Higher tail risks
Hunstad pointed to several other factors that could also raise equity volatility, notably heavy volume in zero-dated options, algorithmic trading and volatility-based selling.
Volatility in equities has skyrocketed since the great financial crisis. There have been 69 equity volatility shocks (defined as movements in the VIX index of at least five points in one day) since 2008,2 compared to just five in 2000 to 2007. The fixed income market has been increasingly volatile as well, with 62 shocks since 2008 versus 15 in the 2000 to 2007 period.3
According to Hunstad, the volatility shocks are directly correlated with money flows for retail-dominated exchange-traded funds. “It’s clear that individuals, who are the price-setters in equity and fixed-income markets, have a lot of passion and emotion. This kind of sentiment is a major factor behind the big gains in volatility,” he said.
With so much volatility in equities and fixed income, Hunstad believes that tail risk will be a greater threat to pension portfolios. “When things go bad, they’re going to go really bad,” he said. “That’s a major consideration, especially when stock-bond correlations are quite high relative to the past. Addressing tail risk means you need to think about risk mitigation as much more than simply adjusting asset allocation.”
3 As of June 30, 2023. Fixed income shocks defined as daily increases of at least 8% in the MOVE (Merrill Lynch Option Volatility Estimate) index.
Sources: Northern Trust Asset Management, Bloomberg
Looking ahead, Hunstad sees a pressing need for pension management techniques to become more precise. The traditional approach — studies of asset allocation followed by implementation — boils down to “crossing your fingers and hoping that the past is going to be like the future,” he said.
To illustrate the need for precision, Hunstad offered an example of different managers overweighting and underweighting the same security or sector. Their positions would cancel each other out, leaving the plan in the position of paying management fees with no benefit. This is a common problem that many plans don’t even know they have, he noted, and they could solve it by using more precise tools and methods.
“There are data, tools and analytics to measure, slice and dice risk across hundreds of different dimensions,” Hunstad said. “It makes the traditional approach look like the Stone Age. We can put these mountains of information, high-quality analytical tools and machine learning to work so they provide a much better picture of where real risk lies in the portfolio.”
2Volatility shocks are any increase in the VIX daily greater than five points.
Source: Northern Trust Asset Management, Bloomberg. Past performance is no guarantee of future results. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index.
Enduring appeal of LDI
As plan sponsors continue to assess equity risk and ensure that their return-seeking portfolio is resilient alongside their liability-driven portfolio — and the latter also evolves to better reach target objectives — overall pension plan management is becoming more effective.
As Allspring’s Hunt sees it, “LDI is definitely the way of the future for many, if not all, U.S. corporate pensions. It’ll continue to grow and evolve and meet the changing needs of plans as they mature and as they get more funded and have more LDI. I think LDI will still be here in five and 10 years, but it’ll look more evolved from where it is today.”
“LDI is a vibrant area with best practices that keep moving forward,” he added. “Even with the largest, most sophisticated pension plans, there’s always something new, something different, something interesting and original to talk about. The next five years should be an exciting time. Most plans haven’t caught up to best practices yet, and there is plenty of room for improvement.”
No two pension portfolios are the same. Not only that, but each plan’s asset size, participant population, liability schedule and funded status are constantly shifting. The need for customization is clear.
Much of the discussion on customized approaches centers around benchmarks. Some pension strategists believe that standard benchmarks such as the S&P 500 or broad fixed income indices have critical flaws, and that plans are best served by portfolio-specific benchmarking.
Using a scalpel cut
LDI portfolios are perhaps the most obvious candidates for customized benchmarking. Franklin Templeton’s Meyers sees the recent gains in funded status as a catalyst for better matching of plan assets to liabilities.
“There’s a need for a more precise, scalpel-type approach to LDI, which is pushing plans more toward custom benchmarks,” he said. “Once you get to fully funded and beyond, you need to build portfolios that are much more specific to the liability risk factors — not just interest-rate and credit-spread duration, but also things like convexity and key rate durations.”
Allspring’s Hunt recommends using suitable LDI benchmarks — and what that looks like will vary by plan size and sophistication. Most plans use combinations of standard indices. But sponsors also should consider working with their managers and consultants to design custom benchmarks based on the combination of liability cash flows and their corresponding yield curve. These might be especially helpful as plans slowly mature and roll down the curve, he said.
Index concentration is a major issue for pension portfolios. Although large market indices nominally include hundreds of stocks or thousands of bond issues, those headline totals can be deceptively large — which exposes portfolios to significant risk.
Northern Trust Asset Management’s Hunstad cites the S&P 500 in this context. “Today, the top 10 names in the S&P 500 make up about 30% of the index’s total capitalization. If you think that owning the S&P 500 means you have a well-diversified portfolio, that’s not true,” he said. “You have a tremendous concentration in a small handful of stocks that are primarily technology focused. This puts pension managers in a very risky place because the performance of a few stocks can determine the plan’s volatility and funded status for the next 12 months.”
But there’s more to the S&P 500’s concentration problem than that, according to Hunstad. He referenced the Herfindahl-Hirschman Index, which antitrust regulators use to measure the degree of market competitiveness in industries. An analysis of the S&P 500 using the Herfindahl-Hirschman methodology calculated that the number of “effective” stocks in the S&P prior to the pandemic was around 120. In other words, about 380 index components accounted for such a small share of total capitalization that they provided no diversification benefit.
The number of effective S&P names has fallen by more than half since COVID. “We’ve gone from around 120 to about 55,” Hunstad explained. “Managers think they’re buying 500 names but, effectively, they’re only buying about 55. When you think about a traditional cap-weighted benchmark, you’re getting a much lower diversification benefit. Pension managers need to be keenly aware of this.”
The major fixed income indices also face a concentration problem based on how they’re calculated: An issuer’s index weight is determined by the size of its total issuance. Standard corporate bond indices, for instance, disproportionately represent huge issuers like Verizon, Ford and AT&T relative to the hundreds of much smaller issuers. As with the S&P 500, owning the benchmark isn’t an effective way to diversify.
Pension managers are finding creative ways to derisk via customization. These are among the out-of-the-box solutions they’re using:
SMALL CORPORATE ISSUERS. Allspring employs a small-issuer, long-credit strategy that exploits the concentration flaw of standard corporate fixed income benchmarks. The outsize weighting of big issuers means that there are many more high-quality smaller issuers that are underrepresented in benchmark-oriented portfolios.
“We think these smaller issuers are a worthy component of pension bond portfolios. They’re good credits, good issuers and a good source of alpha,” said Hunt. “Our strategy maintains the client’s overall exposure to corporates, but changes the composition to be more diversified and balanced across issuers. We can target the smaller issuers in dedicated portfolios or add them to broader portfolios to create more diversification.”
HIGHER-QUALITY, LOWER-VOLATILITY EQUITIES.The traditional derisking move of shifting from equities into fixed income doesn’t work these days, according to Northern Trust Asset Management’s Hunstad, because correlations between the two asset classes are very high. “While this shift is common, investors haven’t necessarily experienced diversification benefits,” he said. “Instead of just looking at traditional cap-weighted benchmarks, they’re filling their equity bucket through higher-quality, lower-volatility kinds of equity strategies. Doing this could materially reduce their funded-status volatility. They’re not overexposed to a few stocks or sectors, and they potentially get better diversification and take less risk.”
EQUITY OPTIONS. Another Allspring strategy, Hunt said, is to step outside the credit universe with “something that looks and feels like corporate credit but isn’t corporate credit” — such as using equity options plus Treasury bonds in LDI portfolios as a surrogate for corporate credit.
As Hunt explained, “The idea is that if you sell a put option on equity, you’re effectively receiving a premium for the option that is akin to the credit spread on a bond. You’re essentially taking on equity volatility and downside risk as a proxy for credit-spread risk. Because if a business is going badly, its stock will do badly, and its credit spread will be wide, so its bonds will do badly. And vice versa. So as an investor, you’re lining up on the same side by using equity options in that manner.”
The correlation is strong, Hunt noted, yet there is diversification to be gained by exploiting a broader swath of the economy, as long-credit issuers are generally concentrated in certain sectors. “The options-plus-Treasuries strategy is a defensive approach in that it generates income while remaining liquid during periods when trading in credit markets can tighten. It’s a bit novel, but it has attractive characteristics if you do it well,” he said, while cautioning that using options in this way is mainly intended for large, sophisticated corporate pension plans that are equipped to handle more complex strategies.
As pension plans work more closely with their investment managers to achieve greater customization that addresses their specific plan funding needs and portfolio objectives, their relationship has evolved into a strategic partnership. It’s no longer enough for managers to handle their allocations and nothing else; they must add value beyond performance.
The level of connection becomes much deeper as the size of the manager’s allocation grows, said Franklin Templeton’s Quagliarello. “As the amount they manage rises, managers must provide investment advice, regular market data and solutions analysis to help sponsors work through decisions with their investment committees. These are all elements of the strategic partnership that plan sponsors want with new managers and expect from their existing manager lineup.”
“Our experience with clients is they want managers who recognize that the world has changed, yields have risen, funded ratios are up and they have to keep moving forward,” said Allspring’s Hunt. “They want people who can help them understand what evolving best practices are and what new ideas are out in the marketplace, do modeling and analytics, be a sounding board and come up with solutions.”