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LDI and Pension Risk Management
June 10, 2024
IN PARTNERSHIP WITH
I

LDI PROVES ITS WORTH

Success brings with it a greater focus on derisking, and for many plans, it raises the welcome challenge of surplus management

The funded ratio of the 100 largest U.S. corporate defined benefit pension plans rose to 103.4% in April, according to the Milliman 100 Pension Funding Index. By this and other market measures, liability-driven investing — which has been implemented across corporate plan portfolios — has been a success. Plan sponsors can take a well-deserved victory lap.

Yet even in their stronger position, pension plans aren’t taking their eyes off their LDI strategy, according to asset managers and consultants. Derisking is now a greater area of focus as plans move down their glidepaths and return-seeking portfolios shrink in size. As plans continue to search for less volatile sources of return and strive to maintain their strong position, new investment strategies are called for.

LDI and pension risk management Webinar

This expert panel of asset managers and consultants shares insights and strategies for derisking and enhancing the end portfolio, viable strategies for surplus management, and the ways that they are delivering diversified asset management along with value-added data and analysis.

Featuring

Michael Moran
Senior Pension Strategist, Client Solutions Group
Goldman Sachs Asset Management
Andy Hunt
Senior Investment Strategist, 
Head of Pension Strategy,
Global Client Strategy
Allspring Global Investments
John Delaney
Senior Director Investments – 
Portfolio Manager
WTW
MODERATED BY:
Howard Moore
Associate Editor, Custom Content
Pensions & Investments
Wednesday, June 12, 2024
2:00 p.m. ET

Several overfunded pension plans — among them, three plans in the Milliman 100 PFI have a more than 140% funded ratio — now also face the challenge of surplus management. IBM’s recent move to use its surplus to reopen its DB plan and offer a cash balance pension benefit sent shockwaves through the industry. Many are now wondering: Should they follow suit?

Andy Hunt, senior investment strategist at Allspring Global Investments, said, “The increase in funded status has happened faster and has gone further than some pension plans were expecting. Some plans now find themselves in a substantial surplus, raising the new question of what to do with it.”

Not every corporate plan has a large surplus. For many, good funding ratios provide a slight buffer, while other plans are still underfunded. Hunt said, “Pension plans are working through the derisking glidepath. Almost everyone is on that journey, just at different places. My longstanding baseline is, If you have a plan, stick to it and keep moving along that plan in a methodical way.”

Addressing the surplus

The pension plan surplus cannot easily be returned to the balance sheet, which is by regulatory design to discourage the practice. “It is hard and expensive to take the money back out of the pension plan and give it to the plan sponsor” or to benefit shareholders, Hunt said. “Instead, most sponsors make use of that surplus through some sort of benefit enhancement for the members of the pension plan.”

“A return to surplus also raises the question of revisiting the investment strategy,” he said. “Growth is no longer the investment objective. Instead, it is protecting the surplus,” perhaps through derivatives exposure.

Another more recent investment solution for mature well-funded plans, which was pioneered in the U.K., is cashflow-driven mandates, or CDI, Hunt said. Here, LDI portfolios don’t just match a plan’s mark-to-market risk, but also its expected cash flows to beneficiaries, he explained. While plans hold increasingly large fixed-income portfolios that are cash-generating investments, typically that income has been reinvested in bonds, so “they aren’t organized to pay that out.”

A solution that has evolved for more mature and more LDI-oriented plans is to match cash flows in and payments out, through a cashflow-driven mandate where “bond portfolios are organized to distribute coupons and principal in a manner that helps meet the monthly benefit payments,” Hunt said. The approach requires customization, as each plan’s cash flows are different. While managing for cash flow risk as well as market risk is not currently widespread in the U.S., it is “an emerging trend and something we talk to consultants about. It is an end-state approach. It is coming.”

Reducing risk

Given their improved funded status on the back of higher interest rates, pension plans across the board — open, closed and frozen — are actively pursuing risk reduction, said Michael Moran, managing director and senior pension strategist at Goldman Sachs Asset Management. He mentioned four key paths that plan sponsors can consider: “One, reduce funded volatility by shifting asset allocation to be more aligned with plan liabilities. Two, tighten the hedge by managing the fixed-income assets against a customized benchmark. Three, diversify the LDI program beyond traditional public investment-grade fixed income,” and fourth, consider opportunistically reducing some liabilities through a partial pension risk transfer.

When it comes to surplus management, Moran said, “there are limitations in terms of what the sponsor can use that surplus for without incurring a very punitive corporate and excise tax.” Still, plans do have some viable options for using the surplus, such as funding retiree healthcare or in an M&A transaction to purchase a company with an underfunded plan, he said, noting that widespread reopenings of closed or frozen DB plans are unlikely.

The acceleration in positive funding status has also led pension plans to focus more on their end-state portfolio, Moran said. “When I get to the desired funded ratio and move down my glidepath, what do I want that portfolio to look like? What’s the split between the immunizing portfolio and the return-seeking portfolio? How do we think about the use of derivatives? What should the split be between public and private markets?” Plans are answering these questions according to their own specific plan objectives and payout needs, he said.

A return to surplus also raises the question of revisiting the investment strategy. Growth is no longer the investment objective. Instead, it is protecting the surplus.
Andy Hunt
Allspring Global Investments

Plan sponsors remain focused on implementing portfolios “that are built to outperform across a wide variety of macroeconomic scenarios,” said Matt Maciaszek, managing director and global head of liability driven investing at Goldman Sachs Asset Management. For instance, inflation can still present an investment risk, even to a well-funded plan if its liabilities are impacted by it. “Inflation risk is an area where a dialogue between the plan’s actuary and the investment team that is managing portfolios is very important,” he said. Plans can pursue several ways to construct portfolios that can better mitigate potential inflation risk, including asset allocation and credit selection, he noted. “For plans with sizable inflation exposure, direct investing in inflation-sensitive securities, such as Treasury inflation-protected securities or inflation-related swaps can be useful hedges.”

More exploration

Pension plans today are enjoying far more options in derisking from a funded-status position of strength, said John Delaney, senior director of investments and portfolio manager at WTW. During the long prior period of being underfunded, the primary objective of plans was to earn their way out of the shortfall, he said. Now, among their many choices, “some plans have accelerated their move to terminate as they have enough cash to get them ready for that state,” he said.

WTW is also engaging with DB plan sponsors who are keen to explore options to support employee financial well-being, after IBM’s recent innovative move to unfreeze its pension benefit. IBM’s decision has led several plans to revisit and articulate their retirement plan objectives, including reaffirming their commitment to the DB plan and the potential for reopening, he noted. “It has led to good conversations between WTW’s retirement consultants and plan sponsors on making sure that we’re considering all the options for the pension plan.”

Even though plans have reached improved funded status, they still need to make sure they are able to maintain it or even continue to improve it, Delaney said. Open plans, in particular, face ongoing accruals and hence have a higher hurdle to maintaining their funding status versus frozen plans. “We need to generate returns over and above the liability to make sure that plans don’t fall backwards from a funding level perspective,” he said.

WTW offers customized approaches, based on each plan’s situation, to help protect funded status. “Some plans can look at a more efficient use of capital, in terms of overlays on the interest rate side, to manage risks while also generating the returns needed for their objectives,” Delaney said. Others may reduce equity exposure and increase allocation to diversified fixed income or hedge funds, or plans could keep their equity allocation but explore other ways to mitigate portfolio volatility.

Macro uncertainties continue to be top of mind for many plan sponsors, Delaney said, which makes it important for pension plan portfolios not to be overexposed to any single risk factor. While the market consensus seems to expect a soft landing, it is merely one of several possibilities. “We want to make sure that clients are not just in equity or bonds, but also in other types of asset classes — whether that be hedge funds, alternative credit, private equity or private debt — where they can participate in the upside but also have better protection in the event of a downside,” he said.

Overview of the 100 Largest Listed U.S. Corporate DB Plans
Source: Pensions & Investments’ Research Center data, sourced from SEC 10-Ks, https://researchcenter.pionline.com/rankings/all/db/overview
Funding Ratio Distribution of 100 largest listed US Corporate DB plans
Source: Pensions & Investments’ Research Center data, sourced from SEC 10-Ks., https://researchcenter.pionline.com/rankings/all/db/overview
II

ENHANCING PRECISION

LDI strategy has evolved to more closely match plan assets and liabilities, and offers more targeted approaches that take total plan performance into account

While corporate plans find themselves in a stronger financial position, they still need to protect their funded status, match liabilities and seek outperformance through asset allocation and alpha within acceptable risk-return parameters.

Growth at any cost is no longer the overriding objective, given that funded status has improved. Asset managers and consultants have stepped up to meet plans where they are today, offering more sophisticated and precise approaches that meet the objectives of both the hedging portfolio and the return-seeking portfolio.

Some of these newer strategies include enhanced fixed income, which incorporates alternatives and private markets; risk-managed equities, which include downside protection; and customization of overall plan liability management. Many plans are also considering total plan performance, which takes a holistic approach when evaluating strategic or tactical shifts.

Three-step approach

LDI investing requires a series of steps in setting strategy and ongoing implementation, said Maciaszek at Goldman Sachs Asset Management. “The first step that an LDI provider should provide, in close collaboration with the plan sponsor and actuary, is defining the market sensitivities of the plan’s liability. That is necessary to build out an asset allocation and manage market-sensitive risks going forward.” The second step, he said, is designing and implementing a fixed-income allocation that tracks the liability. The third step is updating and modeling the program, which occurs on an ongoing basis.

All three steps need to be put into practice when creating a customized portfolio or developing a glidepath for derisking, Maciaszek said. “We help clients develop triggers that lead to higher levels of fixed-income allocations and interest rate and credit spread hedging over time.”

Sponsors looking to improve returns from their liability-hedging portfolio can consider several attractive opportunities on the short- and intermediate-scale. “The first is public corporate credit with a less than 10-year maturity — i.e., intermediate credit strategies,” Maciaszek said, while the second is investment-grade private placements, also with a less than 10-year maturity. Historically, plans had invested in longer-duration instruments, but these often overlooked shorter-maturity instruments better match a plan’s liability, he said.

Maciaszek pointed out that plan sponsors need to consider the trade-offs associated with private credit — a popular solution right now for its diversification and return potential. For instance, he said, “investment-grade private placements are a great portfolio diversifier and typically out-yield public credit, but in order to get those benefits, you have to accept the reduced liquidity.”

Plan sponsors are less concerned about pursing customization manager by manager and more focused on customization of overall plan risk and liability management.
John Delaney
WTW

More plans are reassessing their return-seeking portfolio since improved funded status has reduced the need for seeking out alpha opportunities. “This comes back to evaluating the right mix of public and private assets. Plans may be cutting back or not making new commitments to private markets because their objective is a pension risk transfer,” said Moran at Goldman Sachs Asset Management. Though private assets have higher expected returns, public equities may provide the liquidity that is required for a PRT transaction.

In addition, many plans continue to maintain passive exposure to public equities instead of active management, Moran added. “As the immunizing portfolio has gotten larger, that is where plans want to spend their time. For the return-seeking portfolio, some lean towards passive equity to keep it simple and streamlined.”

Read: Pension Review “First Take”

Total plan performance

“Plan sponsors are less concerned about pursing customization manager by manager and more focused on customization of overall plan risk and liability management,” said WTW’s Delaney. LDI managers continue to take a close look at the plan’s liability structure — including for plans that are in a stronger funded position and need to protect that status — and how it might behave in different interest rate or capital market environments. The amount of interest rate or equity risk the sponsor can tolerate also needs to be considered in any customized approach, he said.

“What really matters is your total plan performance versus your liability. Oftentimes, sponsors and practitioners get focused on the fixed-income portion of the portfolio labeled as ‘LDI,’” when they need to pursue a more holistic approach, Delaney said. That involves looking at potential returns from a total portfolio perspective “which dovetails with fixed-income allocations,” he said. For instance, “investment-grade credit spreads are very tight. Are you better off taking credit spread in the return-generating portion of your portfolio versus isolating yourself to being focused on investment-grade credit?”

Delaney pointed to the attractiveness of diversified or alternative credit, which offers returns well above those required to match the liability. Private credit can play a role in portfolio construction as well. “If you can lock in yields above the liquid counterpart, it is a logical place to put capital to work. Just make sure you’re being compensated for the risk, both of underlying defaults and illiquidity,” he said.

WTW has seen increased interest from sponsors in active managers for equities, both as a source of alpha and as a way to reduce concentration risks found in standard indexes. Delaney also said there are opportunities in hedge funds and real assets, which can mitigate portfolio volatility as well as offer attractive returns.

“We aim to help clients with diversified portfolios, which include alternative asset classes. Plan sponsors should be open to considering new asset classes. Equities could still continue to generate good returns. But we also want to make sure that we’re generating returns from other types of asset classes and exposures.”

Careful calibration

Pension plans that are reassessing their LDI strategy today need to carefully consider current spreads and valuations, said Hunt at Allspring Global Investments. Treasuries are very attractive right now, with real yields higher than they have been since the global financial crisis. “You might not get a better time to buy. It’s a very positive environment for long-duration Treasury bonds. There should be little tactical reason to hold back.”

However, Hunt pointed out that corporate credit spreads — the yield offered above Treasuries —have been compressed due to the high demand for corporate bonds. “The weight of pension plan demand has pushed corporate bonds to a point where they look expensive.” Plans need to consider a spectrum of solutions that complement corporate bonds that includes, for instance, taxable municipal bonds and some structured products, he said.

Hunt expressed skepticism about the popular move toward private credit. “The wall of money chasing private credit has likely diluted the benefit in terms of getting good deals and underwriting,” he said. Neither does he see signs of an illiquidity premium. Further, private credit is often composed of loans and generally not marked to market, unlike a plan’s liabilities, and hence the two don’t move in tandem, he said. “In other words, private credit doesn’t exhibit the same duration, or interest rate sensitivity, as the liability.”

Allspring Global Investment’s approach to liquid alternative credit favors using equity put options as a substitute and complement for corporate bonds, Hunt said. “Theory as well as empirical evidence show that out-of-the-money put options are a corporate bond proxy. We use equity put options in a spread,” he said, which is an options strategy that constrains price movements to a certain range. Such derivatives can be fine-tuned to meet the level of risk that’s acceptable to a plan, he added.

Another set of solutions can be termed “risk-managed equities.” They incorporate downside protection features that make them more liability-like. “Risk-managed equities are somewhat in between corporate bonds and equities in terms of risks. Reducing the tail risk on the equities reduces return opportunities, but it comes to look more like a corporate bond,” Hunt said. While use of these sorts of equity strategies are not widespread, that may change, he added. “We currently don’t see a lot of equity derivatives in the market, but it’s a good fit for pension plans as they mature, and it could become more prevalent.”

Asset allocation of the 100 Largest Listed U.S. Corporate DB Plans
Source: Pensions & Investments’ Research Center data, sourced from SEC 10-Ks. https://researchcenter.pionline.com/rankings/all/db/overview
III

FUTURE PROOFING PLANS

How can pension plans lock in their recent successes? As they look ahead, what are the capabilities of an LDI manager that will help them?

A successful LDI strategy is contingent on a close partnership between the corporate plan sponsor and its LDI manager or consultant, often through customized services that address the plan’s unique circumstances. In some ways, the recent success in funded status has obscured the differing capabilities of these service providers, making it difficult for plan sponsors to distinguish who is truly best in class.

As LDI has evolved to provide more precise and targeted techniques that can better protect funded status, identifying an LDI manager with the right capabilities across both public and private markets can help future-proof plans in protecting their gains — and help them to navigate a challenging macro environment.

Read: US Corporate Pension Review and Preview 2024

A holistic mandate

Plan sponsors are looking for LDI managers who understand their liability, risk and return exposures, with capabilities across many asset classes, said Delaney at WTW. “What we’ve seen is the trend towards understanding total plan performance versus a liability, rather than the performance of one small piece.” OCIO, or outsourced chief investment officer, managers and consultants are providing this holistic focus today, he said.

This holistic approach has implications for asset allocation and investment selection going forward. “There will be more interest in the alternative space, particularly hedge funds, as plan sponsors think about different levers they can pull to continue to generate returns over the liability while not taking on more balance-sheet risk,” he said.

Looking ahead, Delaney’s advice for sponsors is broader still: “Think about where you want to be in terms of your pension plan management business.” It includes redefining the plan’s objectives and aligning portfolio strategies with them. “Make sure that you continue to have ongoing dialogue around your objectives with stakeholders — whether it’s investment managers, the pension actuary or OCIO provider,” he said. “The main way to achieve your objectives is to make sure everyone is on the same page.”

What the best LDI managers provide is being able to evaluate and accurately model a plan’s liability and translate that into an investable benchmark.
Matt Maciaszek
Goldman Sachs Asset Management

Blending managers

When seeking an LDI partner, some qualities are evergreen, said Hunt of Allspring Global Investments. “Pension plans want a consultative, helpful, forward-thinking partner, which is an LDI manager with more than just a product, but with people who can help them do analysis.” This consultative relationship involves delivering market and portfolio analysis and data, as well as providing the range of the investment solutions the plan requires. “It is product-plus-service capabilities,” Hunt said.

But it doesn’t have to be just one LDI manager. Hunt advocated that plans take a more precise, less generic approach by using several managers to implement an LDI mandate. “A plan today probably has more money in their LDI account than it ever had before. It has the room to think about using two or three managers and blending them” in a complementary manner.

This blended approach allows plans to access best-in-class managers for different asset classes, Hunt said, noting that there could be a 50- to 70-basis point return differential per year between the best and an average manager, depending on the asset class. Pension plans no longer need to use the same, sole investment manager from 15 years ago if they aren’t outperforming, he said.

“Pairing and finding ways to put good managers together can be one plus one equals three” as blended managers can provide a more diversified and complementary alpha stream, he noted. Allspring Global Investments, for instance, is able to take a nimble approach, particularly in active credit management. “Best practices are evolving. Ever better portfolios can be achieved. The technology and providers exist.”

Understand your liability

“What the best LDI managers provide is being able to evaluate and accurately model a plan’s liability and translate that into an investable benchmark,” said Maciaszek at Goldman Sachs Asset Management. Success in implementation requires excellent investment technology.

While interest rates and funding levels might be higher than four years ago, so is interest rate volatility, he pointed out. “Plans are trying to evaluate this ever-changing market. They need an LDI manager that they can partner with to navigate these challenges.”

Maciaszek expects to see a greater emphasis on cash flow matching, as well as inflation hedging, as plans grapple with an uncertain moment in the pace and scale of interest rate moves and geopolitical risks. He also sees future growth in multisector credit strategies, which give portfolio managers increased flexibility to invest in structured credit and non-investment-grade fixed income.

“Many plans are in a position of strength. History shows us that periods of overfunding can be fleeting,” said Moran at Goldman Sachs Asset Management. While some plans will use their overfunding to better align assets and liabilities, others will explore ways to use their surplus, while still others will undertake a PRT.

Maciaszek concluded, “What’s most important for DB plans to consider is that it’s a great opportunity to increase their levels of hedging and to lock in that hard-fought improvement in funded status.”