The liability-hedging portfolios that were optimal a few years ago are no longer preferable for most corporate pension plans.
Since the end of 2020, the projected benefit obligation funding ratio for the average pension plan in the S&P 500 has grown from 88% to more than 100%. With the increase in funding ratios, plans have tended to derisk, increasing their liability-hedging assets. As the fixed-income allocation increases, its construction should also change, and we suggest three ideas to consider.
The first is to increase the number of managers to improve diversification of sources of alpha and avoid manager concentration risk. Although the advantages of manager diversification have been muted in recent years, the advantages of multiple managers tends to show up in times of crisis when the dispersion of returns across managers can be large. For example, the dispersion of returns for long government/credit mandates in 2008 was high, with more than 25 percentage points between the 5th and 95th percentile managers. While some of this can be mitigated without adding managers by using lower-tracking-error managers, that may not be the best way to simultaneously manage risk and generate returns.
The second is to increase the customization of the term structure of the liability. When plans have a lot of return-seeking assets, it is often OK for all of the fixed income to be managed against a standard index, such as the Bloomberg U.S. Long Credit index. Customizing the term structure to match the liabilities for such a plan wouldn’t provide much risk-reduction, as funded ratio risk is dominated by the risk of the return-seeking assets. However, as the return-seeking assets decline, the risk from mismatch between the term structure of the fixed-income portfolio and the liabilities becomes more important. Plans can help mitigate their yield curve risk by using a customized liability-hedging strategy with derivatives to better match the term structure of their liabilities. The timing for such customization is particularly attractive now because of today’s relatively flat yield curve, as plans without customized liability-hedging portfolios are exposed if the yield curve reverts to its more normal, upward-sloped shape.
The third idea to consider is adding new sectors through enhanced liability-driven investments (eLDI), which includes strategies that can hedge liabilities beyond traditional government and credit bonds. When viewed as standalone investments, eLDI assets may not be as good of a liability-hedge as long government and credit. However, as liability-hedging assets grow, eLDI instruments can provide sources of fixed-income asset diversification that can help reduce concentration in large debt issuers, and modest allocations can help manage surplus risk. Importantly, eLDI is primarily investment-grade securities, so it can increase diversification and yield without creating significantly more risk. eLDI typically includes securities like long-duration agency collateralized mortgage obligations, investment-grade private credit, real estate debt and other securitized assets.
Many plan sponsors are in a situation they’ve been desiring for years: well-funded and largely derisked, with high allocations to fixed income. To be most effective, we believe that most liability-hedging portfolios should evolve from where they were years ago.
Eric Friedman is a partner and member of Aon Investments’ Investment Policy Services team. He is based in Chicago. Dave Keil is a partner and Aon Investments' U.S. head of sales and institution-directed solutions. He is based in Bannockburn, Ill. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.
