How can pension plans with LDI strategies best measure the risks associated with changes in interest rates and credit spreads? Many plan sponsors are recognizing that solely focusing on market-based fixed income benchmarks may not capture their explicit liability profile. Custom liability benchmarks can bring more holistic governance to the hedging program and approaches can vary widely depending on the objectives of the plan sponsor, said Gary Veerman, Head of LDI Solutions at Capital Group, speaking at Pensions & Investments’ Managing Pension Risk & Liabilities Virtual Series in October. Many plans focus on hedging interest rate risk, he noted, adding “There are certainly also plans that have gone to arguably a more extreme approach to managing explicitly against liabilities, and that’s not only hedging interest rate risk but also trying to achieve a particular credit spread hedge relative to their liability discount rate.”
CUSTOM BENCHMARKS NEED CAREFUL CONSIDERATION
To start with, any custom benchmark should meet key characteristics that have been well defined by the CFA Institute, said Veerman at the session titled, ‘The Pros and Cons to Managing your Hedging Portfolio Explicitly against a Liability Benchmark.’ He explained why each of these desirable characteristics of a benchmark matter:
• Accountability. Asset managers with good governance structures compensate their investment professionals on results. So ultimately, does your structure have a benchmark that maintains that level of accountability?
• Measurability. You ultimately need to come back to your key stakeholders and articulate, is your plan doing what it's supposed to do? And ideally, you're doing so in a clear and concise way.
• Unambiguous. If there is ambiguity or even multiple ways to calculate a return on a liability benchmark, you're probably using the wrong one.
• Specified in advance. Managers need to manage risk. If you do not know what that benchmark is, you will not have the ability to manage risk. An example is if you use discount curves that are actuarially driven, with many not be available until after month end.
• Investability. You need to give your managers a properly diversified universe of securities that are liquid and provide your manager the ability to achieve the desired results, whether that’s the excess return target or just keeping up with that particular benchmark.
Capital Group works with pension fund clients to build LDI strategies that meet these criteria, Veerman said. Getting overly complicated with benchmarks may not serve clients well either, he said. “At the end of the day, as an industry, we love to create new solutions for clients. I think we've taken it a bit too far to make commitments around managing against something like an above median curve where you’re actually removing the lower yielding bonds and increasing the discount rate to effectively make your liabilities look lower. You really need to make sure that you have that liability hurdle context. While market-based fixed income benchmarks are not perfect, they're likely still our best way to get to that end goal to achieve all those objectives that I talked about earlier,” he said.
Within their LDI strategy, plan sponsors need to look at their interest rate hedge ratio and credit spread ratio in a broader context. For a pension plan looking to mitigate the variability of the underlying Treasury curve for their discount rate, they could access a wide range of eligible tools available in the marketplace, whether that's coupon-paying Treasuries, Treasury STRIPS, or interest rate derivatives, Veerman said. “You can do that effectively and efficiently, and provide the accountability to a manager relative to an interest rate hedge ratio.” Many sponsors have hired a completion manager to get more explicit around fine tuning their interest rate hedging portfolio.
“The credit spread hedge ratio is the hard one,” Veerman said. “How do you measure credit spread risk against even an AA corporate bond discount rate? There's DTS (duration times spread). There's OAS (option-adjusted spread). There’s spread duration. There's all these metrics, but no particular metric has proven to be a perfect solution to get you to a point of saying, "I’m confidently hedging X% of my plan liabilities’ credit spread risk." Credit spreads are critical to liability valuation, and Veerman agreed with others on the panel that sponsors need to include their equities exposure. “Do you take account of your equities as an explicit credit hedge ratio? No, but at the same time, one of the worst-case scenarios for a plan can be that you actually end up being over credit spread hedged because you have equities, and then you end up trying to fine-tune some imperfect credit spread hedge ratio on the fixed income portfolio.” This is where prudent asset allocation decisions come into play – keep your credit portfolio sized right based on your equity allocation and really allow your managers’ a broad investment grade universe to add value, Veerman said.
What about plan sponsors facing the challenge of constructing an appropriate hedge to match the duration of their liabilities, given that fixed income managers could end up buying the same portfolio of investment grade bonds? Veerman said that in the first quarter of this year, there was a 600 basis point divergence of long credit manager performance. “That’s a great case study to say that not everyone is holding the same bonds just because the benchmark holds them. But size has become an issue in our industry. If you're a $50 billion long credit manager, are you really closet indexing, or are you actually able to be active versus that benchmark? So I would argue that the foundational piece that you need to get right is the idiosyncratic risk from the security selection component of credit, and this can be quite challenging if you are forced to buy bonds close to the index weightings.” If you get security selection right, you are likely introducing an excess return stream that is relatively uncorrelated to the factors that impact changes in funded status, he added.
Plan sponsors should have realistic expectations around the tracking error relative to their liability, Veerman said. “We accept tracking error as a measure of risk in this industry because it's the best we have. I would argue fixed income tracking error is a very challenging statistic because you either get your 3-4% and your money back or you get 60 cents on the dollar back, and that's not normally distributed.” Ultimately, any explicit liability benchmark needs to provide more clarity to the plan sponsor around how much risk you are taking relative to liabilities, said Veerman. “I would actually say that we, as an industry, have actually gone to the point of trying to create a level of precision that I do not believe produces better outcomes, or is able to be communicated clearly and effectively in the right governance structure with the plan sponsor.”
“At the end of the day, we can all debate the liability benchmark and what it should be, but we all know the ultimate goal is to pay benefits to the plan participants. That's the ultimate benchmark. The question is how do you get there?,” Veerman said.
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