“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.”