FSA, LDI Team Co-Chair, Multi-Asset Strategist, and Portfolio Manager
CFA, CAIA, LDI Team Co-Chair, Fixed Income Investment Director
Corporate plan sponsors have had a lot to think about lately, from contribution decisions driven by tax reform to investment reallocations stemming from rising funded ratios. To help with next steps, Wellington's LDI Team Co-Chairs offer thoughts on common questions they've been hearing from plan sponsors.
1. Why adopt an LDI strategy?
Trainor: This question often comes from an investment staff member who wants to make the case to the CFO or investment committee that the plan should adopt LDI. To get to the answer, we pose another question: Are you being fully rewarded for the risk that your plan is taking? Often the answer is no.
What do we mean by “unrewarded risk”? Let's say a plan is using a static 60%/40% equity/bond mix. This mix has a wide range of potential funded-ratio outcomes. On the downside, the plan might drop further into deficit. On the upside, it might generate a large surplus. But that upside might not really be upside if it results in trapped surplus. And that's a problem if the plan is taking on a lot of downside risk in pursuit of that unrewarded upside outcome.
It's worth explaining trapped surplus a bit. First, taxable plan sponsors cannot reclaim excess assets in their plan without significant excise tax penalties — even after the last benefit has been paid. Second, plan sponsors cannot contribute less than $0 to their plan, limiting the cash-savings benefit from building up a large surplus. Therefore, taking excess risk in a plan's investment portfolio potentially creates the risk of both plan deficits on the downside and “trapped surplus” on the upside, with no offsetting benefit.
By opting to use a glidepath, a plan can be more focused on protecting its funded status as it improves, rather than pursuing unrewarded risk. It can be a very rational economic means of taking risk in the plan.
Some plans might be hesitant to adopt LDI because reallocating from return-seeking assets to liability-hedging assets might mean reducing the expected return on assets (ROA) assumption, resulting in higher expense and lower earnings. But a glidepath can potentially be appealing because the derisking occurs incrementally and against the backdrop of an improving funded status, which might help offset the effect on earnings of a lower ROA assumption.
2. What's a simple first step we can take to derisk?
Trainor: On a related note, we sometimes hear from plan sponsors, “It's going to take months to implement LDI, but our plan has too much risk. What's an easy first step?” We think equity strategies that seek to outperform when markets struggle can be an answer. Figure 1 illustrates a hypothetical strategy that captures 95% of the return of the S&P 500 in up months but only 85% in down months. Not surprisingly, the strategy adds value when the S&P 500 falls, including during bear markets (shaded areas). But it also holds its own in bull markets, when it might have been expected to struggle. Strategies that seek to limit downside in essence leverage the power of compounding.
We are sometimes asked how to implement this type of approach and whether it requires using equity options. While options can be part of the tool kit, plans can find equity strategies, either fundamental or quantitative, that fit this profile. During the due diligence process of a manager search, plans should ask questions to understand how the manager seeks to protect on the downside and review the manager's up/down capture as a proof statement.
3. Should we precisely match our liability with an unfunded overlay?
Cole: The modeling we've done suggests that precisely matching the key rate durations of the liability cash flows across the curve can introduce a lot of cost and complexity — when adding synthetic overlays, for example — and that there may not be a significant reduction in funded-ratio volatility. A close (but not necessarily perfect) curve match may suffice, provided that interest-rate and spread risk are well hedged.
This also suggests that plans may want to avoid overengineering their liability-hedging benchmarks. Our research suggests that plans may be able to achieve their desired level of funded-ratio volatility by blending standard market indexes in a manner that targets an appropriate level of interest-rate and credit risk. We have found that a benchmark with 75% long corporate bonds and 25% long government bonds could suit plans with a liability duration of about 13 or 14 years, though of course every plan's specific needs will vary.
4. We plan to derisk but are worried about investing in long corporate bonds when spreads are tight. What can we do?
Cole: Many plans are anticipating large contributions that will move them past their next funded-ratio trigger and therefore need to be allocated to long-duration fixed income, yet they are hesitant to invest in long-duration credit given how tight spreads are. One way to approach this is not to rush in but instead be a little more opportunistic and watch for dislocations that can arise — for example, when the market endures a significant increase in supply over a short period, as we saw earlier this year. To prepare for these opportunities, a plan might consider a flexible approach to funding its liability-hedging portfolio — e.g., initially fund a Treasury portfolio that is duration-hedged to the plan liability and transition that portfolio to long credit as market opportunities arise.
5. What else can we do to help limit funded-ratio risk without sacrificing too much funded-ratio growth potential?
Trainor: We think plans should consider what we call “bridge strategies” — investments that sit within the return-seeking portfolio but may play a dual role of providing potential downside risk mitigation in times of funded-ratio stress while still participating in up markets and contributing to funded-ratio growth in benign environments. Specifically, we define bridge strategies as those that combine return-seeking and liability-matching characteristics by offering low expected equity beta and moderate interest-rate sensitivity. Examples include strategies focused on infrastructure investments, income-oriented equities, low-volatility equities, long/short equity investments, and fixed income credit sectors.
6. Why should we consider using active management for STRIPS?
Cole: Many plans we've spoken to are thinking about using STRIPS in order to lengthen their portfolio's duration in a capital-efficient manner. But while STRIPS are derived from government bonds, there are some structural issues that we think create opportunities in the STRIPS market for managers making active security-selection decisions. It is important to remember that the STRIPS market is relatively small and considerably less liquid than the nominal Treasury market. In addition, central banks have been pulling back on their purchasing activity in the US government bond markets, and dealer sell-side balance sheet constraints have reduced dealers' ability to act as liquidity providers to the market. As a consequence, security-level pricing in these markets has become less homogeneous, creating more opportunities for experienced managers to potentially take advantage of security-level pricing anomalies.
7. How do we prepare for a scenario of rising interest rates but poor equity returns?
Trainor: Plans have been waiting years for rates to rise and ease pressure on their liabilities, but funded ratios could stagnate — or even decline — if rising rates are accompanied by negative equity returns. What could bring about this environment? One possibility is that an upside inflation outcome could lead the Fed to tighten more aggressively than anticipated and put pressure on margins.
We see two key considerations for plans: First, take steps to help “lock in” some of the gains from higher rates. As noted, rates might rise, but funded ratios could stay level or even decline if equity losses outweigh the effect of lower liabilities. Our research shows that funded ratios have historically declined moderately on average in this environment. In the event of such an outcome, plans using a glidepath that derisks based solely on funded ratio would not take any derisking action. But we think that could be a missed opportunity to respond to higher rates. One potential solution is to add interest-rate triggers to the glidepath that systematically extend duration and increase the liability hedge ratio as rates rise. This may help lock in some of the liability-relative gains resulting from short-term increases in rates.
We also think plans can diversify return-seeking portfolios by adding strategies that could potentially outperform traditional equities and help mitigate funded-ratio losses in this type of environment. Examples include inflation-sensitive assets that may perform well in low-growth regimes, such as TIPS or infrastructure investments designed to pass through inflation, and absolute return strategies with little or no sensitivity to equities or rates.
For more on these topics, visit sites.wellington.com/ldi
Contact:Amy Morse, Director of Pension Strategiesagmorse@wellington.com