A BETTER ROAD MAP TO MEET PLAN OBJECTIVES

“The word ‘evolution’ is really key in our discussion of LDI because no one is suggesting that we have seen, or need, a revolution,” said Brett Cornwell, CFA and Client Portfolio Manager in Fixed Income at Voya Investment Management. “Historically, what we might call LDI 1.0 has worked and has provided a good foundation for plan sponsors focused on de-risking their plans and hedging their liabilities. It’s natural for plans to evolve their LDI programs as they become better funded and have a clearer road map to achieve plan objectives and to meet the future expected promises,” he said, at Pensions & Investments’ Managing Pension Risk & Liabilities virtual conference in October.

“This evolution has often led to higher allocations to fixed income, which has largely resulted in increasing exposure to corporate credit that has introduced unintended risk factors such as issuer concentration. Plan sponsors may think they can diversify by adding additional managers, but if the managers are all fishing from the same limited universe of corporate bonds, they are not be getting the level of diversification plan assets need,” Cornwell said. “To be clear we are not suggesting a wholesale move away from corporate credit, but we do advocate for adding non-traditional asset classes such as investment-grade private placements, commercial mortgage loans and securitized assets, to enhance the LDI program and reduce the impact of issuer concentration. Ultimately, it will improve the efficacy and efficiency in the way plans hedge their liabilities,” said Cornwell, speaking at the session titled ‘The LDI Evolution.’

Some plan sponsors can have very long dated liabilities, at a 16- or 18-year duration, with a few even going out to 20 years and beyond. “The longer you go in duration, the smaller and more narrow the opportunity set becomes for plan sponsors to get creative in terms of hedging that long-dated liability,” Cornwell pointed out, noting “There are very few assets that have duration that long, and there are limitations to using derivatives to extend duration. So it really becomes this exercise of ‘how do you optimize the tool set that you have available?’”

“Plan sponsors need to consider different data points with this notion of diversification, as it's not just return-seeking or liability hedging, but there's also diversification within the fixed income liability hedging bucket”, Cornwell said. “The other factors to consider are the plan’s funded status as well as whether the plan is open, closed, or frozen. These factors all play a role in developing a liability hedging strategy.”

In the low interest rate environment, which is likely to persist for some time, some plan sponsors may be thinking about whether they should hedge at all. “When we look at low rates, we have to frame it in the context that rates have been low for a while, and we find it difficult to believe there's a scenario that's going to cause rates to move materially higher in the near term,” Cornwell said. “In the U.S., subzero interest rates is not Voya's base case, but that doesn't mean that it's impossible.”

“When considering interest rate risk at these levels, a key factor that we think is underappreciated is convexity. A 50-basis-point move in rates today will have a much larger impact on a plan’s liabilities than a 50-basis-point move experienced in a higher rate regime,” he explained. “So it's incumbent upon plan sponsors to be more aware of the duration mismatch between their assets and liabilities, given the outsized impact that rates could have at such low levels. While that is more challenging to manage now, the level of interest rates shouldn’t necessarily inform whether or not to hedge”, Cornwell said. “In our discussions with sponsors about whether to hedge rates, it’s not about the level of rates as it is about the plan’s key objective. If the key objective is to manage the plan toward solvency and liquidity and to minimize funded status volatility, that will inform whether or not you will hedge the interest rate risk, regardless of current interest rates levels.”

“As pension plans have invested over time in long duration corporate bonds to hedge their liabilities, the universe of available long duration high quality bonds has shrunk,” Cornwell said. “When constructing the discount rate, you're constructing it based on, typically, a pool of AA-rated or higher bonds. If a bond used in that calculation were to be downgraded, it simply gets removed from the pool of bonds used to determine the rate. The result is that the discount rate doesn't have a memory of downgrades. Your portfolio, on the other hand, has exposure to credit events. This makes it very difficult to keep up with the growth rate of the liability that's based on that AA discount rate, as it behaves not like AA credit risk, but resembles a credit quality a bit closer to AAA.” he explained.

‘Within the corporate bond universe, I often refer to downgrades risk as being like high blood pressure, in the sense that it's a silent killer that can damage your asset portfolio,” Cornwell said. “Plan sponsors who want to mitigate downgrade risk should consider expanding from the traditional corporate bond opportunity set into other spread sectors. “Incorporating assets that are reasonably correlated to the discount rate being used can be an effective way to enhance diversification,” he said. “This is where investment grade private placements can play a role because they not only address the concentration issue, but also mitigate downgrade risk because of their covenant packages,” he said. “To stick with the evolution theme, it's to evolve beyond the traditional investment grade corporate universe and certainly beyond just the AA risk which leads to overly concentrated portfolios.”

“There’s also been an evolution in the way that corporate plan sponsors look at benchmarking the success of their LDI or hedging portfolio,” Cornwell said. “The early trend to use market-based benchmarks such as the Bloomberg Barclays Long Government/Credit meant that asset managers were anchored to the benchmark’s investable universe, even if they were given the flexibility to invest outside of the benchmark. There’s been an evolution to create an investable benchmark that minimizes the tracking error to the liabilities,” he said. “It could be a combination of market-based benchmarks or a more custom approach and, ultimately, we're starting to see pure liability-based benchmarks,” he said. “It removes the shackles of the asset manager where they're not anchored to a benchmark to define the investable universe. This approach to benchmarking opens up the tool kit to build a multi-sector portfolio where you have the ability to be creative in building a more efficient and effective hedging portfolio.”

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