LDI immune to COVID-19 but lack of diversification persists

Bookended by two “once in a generation” crises, the past decade was full of surprises, including a double bull market for both equities and fixed income. However, despite record-breaking returns in equity and fixed-income markets, the funded status of the pension plans of companies in the S&P 500 index, in aggregate, exhibited an L-shaped recovery.

To answer why funded status did not keep up with soaring equity and bond returns, Voya Investment Management analyzed publicly available information published in the annual reports of companies in the S&P 500. According to the analysis, the main culprit for the L-shaped recovery in funded status was plan sponsors’ decision to wait at the gates of their glidepaths for interest rates to rise. They never did.

“If the last decade taught us anything, it’s that sponsors do not need to wait for glidepath triggers to derisk. In the 10 years following the global financial crisis, plans that allocated more to long duration credit achieved a similar level of asset return with far less volatility compared to plans that held more equities,” said Oleg Gershkovich, LDI strategist and senior actuary at Voya Investment Management.

For plan sponsors, the good news is that the lessons learned from the period following the global financial crisis left them better prepared for the COVID-19 market dislocation.

“There has been a big shift in understanding the importance of an LDI program, especially in the last five to seven years,” Gershkovich said. “Right after the great financial crisis, everybody thought rates were going to rise, but that never materialized. Eventually, everybody started to realize, ‘We need to do something, we can’t wait much longer for rates to rise.’”

According to “The Lost Decade,” a recent white paper written by Gershkovich and Brett Cornwell, client portfolio manager, fixed income, at Voya, many plans had increased their fixed-income allocations by the time the economic crisis related to the spread of COVID-19 took hold this year. Gershkovich said that almost half of the pension plans he and Cornwell studied had fixed-income allocations of more than 50% this year vs. about 5% of plans in 2007.

“The higher the hedge and the greater the allocation to fixed income, the better they weathered the storm. Plan sponsors that committed the time to develop a [liability-driven investing] strategy and carefully managed hedge ratio, when they looked back on March, were very pleased with what they saw — a very steady funded status,” Gershkovich said.

Looking ahead, Gershkovich and Cornwell expect the focus on derisking will continue to grow. This means a greater emphasis on fixed income and de-emphasizing equities in the portfolio.

An asymmetric payoff

“Pension plans are not hedge funds. Their objective function (when sufficiently funded) should be geared toward solvency and liquidity — not maximizing returns. In fact, qualified plans in the U.S. operate as non-profit insurance subsidiaries since an overfunded position is subject to an excise tax (assessed by the IRS to limit profits from pension fund raids that were rampant during the 1980s), while underfunded plans incur onerous [Pension Benefit Guaranty Corp.] premiums and mandated contributions,” Cornwell explained.

In short, there is an asymmetric payoff when it comes to taking equity risk. Plans receive limited upside when equities rise and incur all of the downside when equities underperform.

“The equity markets were certainly tempting plan sponsors to make a tactical shift to take advantage of something that really looked like a no-brainer,” Cornwell said. “But here is the catch: You have to get the timing perfect because we are looking at an equity market that clearly rebounded sharply off the bottom, and we would argue that there is a little bit of a disconnect between the financial markets and the broader global economic environment.

“Ultimately, we think whether you re-risk or not should really be informed by what your objectives are, not what is tempting in the marketplace,” he said, “because that could lead to some ill-informed, very short-term tactical decisions that can have very real long-term implications that may not prove positive.”

Gershkovich concurred. “Don’t be doubly fooled by equities and rates,” he said. “The former introduces an incredible amount of volatility. And as for the latter, rates can still go lower, so why continue to take risky bets? It can work against you. We don’t know where this pandemic is going with outbreaks in the Midwest, colleges sending students home, and protests and elections, it’s difficult to time the markets.”

Expanding the opportunity set

Better-funded plans should “continue to stay the course, not re-risk and continue working on ensuring its funded position by transitioning to duration-matched assets beyond the regular corporate credit. So, look to diversify,” Gershkovich said. “And lower-funded plans — which may not have the wherewithal to contribute to reach a better-funded position but want to have some exposure to growth assets — should consider using derivatives to help achieve better interest-rate hedging. They are incredibly useful.”

Cornwell said that while most pension plan officials today understand LDI, “I don’t always think better understanding leads to rational action,” he said. “We continue to see plan sponsors do things that we might consider irrational in the context of their overall objectives.”

That means that LDI is still a work in progress for many pension plans — not only in making more rational long-term investment decisions but in determining the optimal mix of fixed income assets, often beyond traditional investment-grade corporates, to make those decisions work.

From a diversification perspective, adding non-traditional asset classes — such as investment-grade private placements, commercial mortgage loans and securitized assets — can enhance an LDI program.

“Incorporating assets that are reasonably correlated to the discount rate that you are using is an effective way to enhance diversification,” Cornwell said. “We are not suggesting a wholesale move away from corporate credit, but rather taking what has worked well and enhance that portfolio. This is where investment grade private placements can play a role because it addresses hidden risks such as concentration risk, credit rating migration and defaults. Downgrades can ultimately do some damage to your hedging portfolio.”

“At Voya, we have demonstrated that a diversified multisector credit portfolio can be constructed to outperform the liability over time with better risk-adjusted returns compared to using a blend of market-based government and credit benchmarks,” Gershkovich said. By exploring non-traditional investment grade asset classes, Voya constructs portfolios with securitized credit, collateralized mortgage obligations and private placement built on a foundation of investment-grade corporates.

Maintaining a hedge portfolio is also a priority in an LDI strategy, Gershkovich said. “For us, it is tracking and monitoring every day, not losing sight of the liabilities,” he said.

Such hedging monitors served at least one Voya client well when the economy tanked this year. “In March, we were doing daily estimates of the plan’s liability,” Gershkovich said. “We were getting the assets from the plan sponsor and were checking the interest rate hedge ratio to determine if we needed to act. And we did have to take action several times in March to get the hedge rate back down to 100%. The plan weathered the storm unbelievably well.”

The current economic downturn need not deter plan executives still on the fence about implementing LDI, Cornwell said. “Re-risking with equities can be a perilous endeavor while high-quality, liability-compatible fixed income instruments are on sale and can enhance or expand upon any fixed income allocation, resulting in a robust liability hedging program. Rates are historically low, but they can go lower. Interest rate risk will continue to be the dominating risk factor for a pension plan in a zero-rate world and should be addressed head on.”

For plans looking to adopt LDI, “The opportunity set is not a heck of a lot different now than it was on Feb. 28, just before the COVID-related market storm,” he said. “Spreads are a little bit more attractive and there has been some change in the composition potentially of what we have seen in the market. Durations have extended. There have been a lot of companies coming to the market to issue debt. If LDI makes sense, then you just make the most out of whatever the opportunity set is today.” ■

Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions, and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.