GLIDEPATH STRATEGIES ARE EVOLVING
Innovation in liability-driven investing continues to drive the adoption of investment solutions and risk management approaches by pension plans. With the recent strong equity market performance improving their funded status, many plans are adopting a more dynamic approach and moving down the glidepath to further derisking.
As plan sponsors consider some of the current LDI approaches, not only do they need to navigate the current market environment of low yields and high equity valuations, they face the challenges of potential inflationary pressures and uncertainty over the spread of the COVID Delta variant.
“There are a lot of current and emerging best practices that are moving the LDI ball forward,” said Andy Hunt, CFA, head of fixed income solutions at Allspring Global Investments (formerly Wells Fargo Asset Management). “There is a lot of money in motion as the glidepath progresses from equity to long-duration fixed income. Topic No. 1, 2 and 3 on the minds of all pension plans is how to deploy that money most efficiently and continue to make funded ratio improvements.”
“A number of tools, from underlying investment products to total plan advisory services and technology resources, are critical in order to effectively manage pension liabilities and mitigate overall funding volatility,” said Thomas Kennelly III, managing director and head of investment strategy OCIO at State Street Global Advisors. These tools and solutions often include outsourced chief investment officer services and completion management, he said. Not all of the investment tools, such as derivatives, are new but, Kennelly added, “they’re more widely embraced in order to provide greater precision and capital efficiencies.”
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WIDER RANGE OF OPTIONS
The improved funded status of pension plans — driven largely by positive equity market performance, but also by rising interest rates earlier in the year — has had additional consequences. “We are seeing more pension risk transfer activity by our clients,” said Kennelly. He noted that while the SSGA OCIO team guides investment committees in overall asset-liability management through a pension risk transfer, State Street also has an independent fiduciary team for PRT transactions. “The fiduciary team stands between the sponsor, who is looking to get the best price, and the participant, who obviously would like the best insurance carrier from a credit standpoint. An independent fiduciary can advise the client on the ultimate annuity selection in adherence with the Department of Labor Bulletin 95-1. We’ve collectively seen a real uptick in activity here.”
Also notable in LDI today is the growing role of equity strategies that are aimed at mitigating volatility and other risks to the growth portfolio. “Using defensive equity strategies has become a mainstay of many asset-owner portfolios,” said Rupert Watts, senior director of strategy indices at S&P Dow Jones Indices. “These are strategies that have historically tended to outperform during market downturns and may have a lower beta than the market to help reduce the intrinsic risk of the portfolio.” He also pointed out that “just because a strategy is defensive, the return isn’t necessarily lower than the broad equity market over the long term.”
When looking at the liability portfolio, the painfully low yields today remain a challenge for plan sponsors. “When sponsors look at their liability risk, it’s typically going to be based on corporate spreads over Treasuries,” said Jason Giordano, director of fixed income indices at S&P Dow Jones Indices. “They look at the current yield curve. Although the curve has been steepening, if we look at implied forward rates, such as the three-month forward rates, it’s at about 1% for the next year.” (See chart on benchmark yields.)
LOOK AT BOTH SIDES
“Pension plans should not change their risk framework because of the presence of some of these short-term issues,” the low yields and high equity valuations, said Todd Thompson, senior portfolio manager at Reams Asset Management, an affiliate of Carillon Tower Advisers. Instead, he said, “they’ve learned from the past in regard to trying to time the market. We’re seeing more defined action on derisking [when] trigger points are met along the glidepath. Rather than being preoccupied with interest rates, a more prudent defensive strategy would be to execute your LDI plan and exit growth assets.”
“The big question — which is more of a rhetorical one that we ask — is, Which market is more overvalued or unanchored from reality, the interest rate market or the growth asset market? Or to say it [another way]: Do the biggest risks reside in the liability-hedging portfolio or in the growth-asset portfolio?” Thompson said. “Given the visibility of the bond market and its prevailing ultra-low yields, many plan sponsors have a natural tendency to place a disproportionate amount of attention here as the most critical area of concern. However, that’s absolutely not the way to look at it. You have to look at both sides of the portfolio with a discerning eye and realize there can be hazards to both growth and hedge assets.”
PAST IS NOT PROLOGUE
The strong improvement in funded status for plan sponsors has been a welcome outcome, said Kennelly at State Street Global Advisors, but the past is not prologue in investing. “We think the regime is changing in terms of the economic and policy backdrop. There are changes afoot in terms of what’s been driving markets for the last ten years, post-financial crisis. The future likely will be different, and it could be choppy. So, having the right partners, the right investment process, the right governance and the ability to think about the portfolio more dynamically will be a big change.”
Know that “what the market giveth, the market can taketh away, and realize that this glorious change in funding status has been driven by growth assets, not by rate movement,” said Thompson. “Be disciplined, and execute on this process that people have studied ad nauseum and follow through. You need to hit triggers and reduce risk, just as the spirit of LDI suggests.”
As plan sponsors navigate what’s ahead, they are looking for more inventive ways to manage LDI. “The focus of plan sponsors’ attention largely is about how to do the LDI portfolio better. Solutions are there to be had. It’s fun, it’s exciting and there’s a lot of new stuff around,” said Hunt at Allspring Global Investments.
Looking ahead, “we’re seeing a lot of interest in defensive index strategies and liquid alternatives. Demand for customization continues to grow as well,” said Watts, noting that S&P DJI is in regular dialogue with asset owners and other key stakeholders about indices that can better meet their needs for LDI performance measurement.
RENEWED FOCUS ON RISK MITIGATION
An improvement in funded status has allowed several pension plans to derisk by moving some assets out of the growth portfolio. But it’s important to manage the remaining growth asset exposure that is still vulnerable to market volatility and the possibility of severe drawdowns.
“Returns on the growth portfolio are not an ATM. You can’t just expect them to deliver a historical actuarial average return year after year,” said Thompson at Reams Asset Management. He pointed out that returns on equities vary wildly, by year and by decade. “From 1989 to 1999, the S&P 500 Index returned 18% a year per annum. It was a glorious decade,” he said. “Well, what typically happens after a glorious decade is a not-so-glorious one.” Over the ensuing 10 years, the S&P 500 Index’s average annual return, including dividends, was only marginally positive. “One should ask, Are we faced with a similar environment today, considering the S&P 500 Index has compounded at almost 15% per annum since 2010?”
“Today, alternative monetary policy has led to a lot of excess capital chasing a limited number of financial assets, which has translated to stretched valuations. That tends to have a crowding out effect and pushes people into taking different risks,” Thompson said, observing that at a number of pension plans, more funds are flowing into alternative assets, such as private equity.
Thompson’s advice to plans: “You need to be very cautious of your expectations for growth assets. Take a broader perspective on where we are in the monetary and business cycle and what alternative monetary policy has done in its impact on valuations.”
CONSIDER DEFENSIVE STRATEGIES
Diversification and defensive strategies could be the answer to the quandary of the growth portfolio facing pension plans. “Increasingly, asset owners appear to be more focused on true risk diversification as opposed to asset class diversification,” said Watts of S&P DJI. “We’ve seen increased demand for uncorrelated index alternatives, specifically liquid alternatives, with the first pick being risk parity. This strategy allocates index constituents across diverse asset classes which tend to react differently across growth and inflation environments, and weights [them] in such a way that each asset class is in balance, from a risk perspective.”
Watts explained that at S&P DJI, risk parity index strategies are classified as a subcategory of liquid index alternatives. “‘Liquid alts’ is a loosely defined term but, broadly speaking, it includes strategies that are liquid, exhibit modest to low correlation to equities and often employ ‘nontraditional’ index methodology, such as long/short models or the use of leverage or derivatives. We define it to include strategies such as risk parity, risk premia [or] long/short factors, and managed futures.”
Defensive factor indices also remain popular, he said. “These reflect strategies that tend to outperform during stress periods and may have a lower beta than the market, [helping] reduce the intrinsic risk of the portfolio. Low-volatility factors, quality factors and dividend-growth indices — those with companies that have increased dividends consecutively for a minimum number of years — all fall into that category of defensive strategy indices,” Watts said.
Quality factors, or companies with sustainable earning power, tended to outperform during the market turmoil related to the COVID pandemic, he said. “Quality and other style factors may react differently to the macro cycle. That’s part of the potential utility of factors and why combining different factor styles could make sense.”
A DIVERSIFIED ASSET BASE
Given their increase in funded status, for plan sponsors “the objective is to not give back the gains that have been realized in the last six to 12 months” in their growth portfolios, said Kennelly at State Street Global Advisors.
“We’ve always been believers in diversification and using other assets besides equities as in, for instance, real assets: commodities, infrastructure and natural resources. These are ways to manage around inflation. For plans with a longer time horizon, private markets in real estate, credit and equity also provide benefits to overall risk management in the growth portfolio. There’s smoothing from a market-to-market standpoint and some diversification benefits in the total portfolio sense,” Kennelly said. “We’re also big believers — for certain clients who have investment committee approval — in using synthetic instruments, like bond and equity futures, to manage both risk and liquidity.”
Interestingly, some strategies typically classified as defensive have not kept pace with broad growth-oriented strategies. “Hybrid assets [and] less risky, low-beta strategies haven’t provided the top-line absolute returns that clients have realized in riskier assets. I put hedge funds in that category. Value stocks and low-volatility equities did poorly.”
However, Kennelly noted, “Going forward, we think there’s diversification benefits to these types of asset classes. With generally lower duration than growth equities, they could perform better in a rising rate or inflationary environment. Their cycle could look different from the past.”
RESPOND TO THE RISK CYCLE
It is important for plan sponsors to realize that as their pension funds get closer to their end state, investment needs change, Kennelly said. “Risk management needs to take precedence as the hibernation phase sets in. Previously, they might have had larger exposures to broad equities and to private assets for growth. Now it’s actually the opposite. It’s shifted to winding down the private-market exposures. Managing this end-state portfolio is quite challenging in order to maintain funded status. It requires the right partner,” he said.
Allspring Global Investments’ approach is to combine risk management and growth through what Hunt terms “liability-friendly return-seeking” strategies. “These are hybrid strategies — not quite a bond, but much more bond-like than a regular equity portfolio,” he said. The strategies are designed and managed with a plan’s liabilities in mind, and correlation to the liability can approach 80%, he noted.
Hunt offered an example of a long-credit alternative. “It is an equity derivative product with some bond-like characteristics. It uses equity options in a structured way to emulate or mimic credit spread on a long corporate bond and puts that on top of the Treasury portfolio to create a synthetic long credit. It is a way to avoid today’s tight credit spreads.”
Another example is a risk-managed equity overlay product, Hunt said. “This is a derivative overlay using futures, options and dynamic beta management to curtail tail risk in equities,” or the risk of unexpected systemic drawdown, he said. “Tail risk management through derivatives helps to protect an equity portfolio from those acute drawdowns that happen in times of stress and strain,” Hunt said.
These strategies, as well as low-volatility products, can be used by sponsors separately or in combination. “They are like pieces in a jigsaw puzzle,” Hunt said. “That’s where the advances are being made, in product solutions that sit together, are fit for purpose and are helpful” in meeting pension plan objectives.
ADVANCES IN LIABILITY HEDGING GET CREATIVE
“With low yield [in the current market], there’s opportunity to think, Can I add some value? The answer is yes,” said Hunt. “When you’re looking at 2% to 3% yields, if you can add 1% to 2% alpha, suddenly it’s quite material.”
Hunt said Allspring recently unveiled two new strategies for generating alpha in the hedge portfolio. “The first approach is structuring a more inclusive set of opportunities, which we term LDI-plus,” Hunt said. “It’s not just investment grade corporate credit, it can be long-duration high-yield, taxable municipal bonds, long-duration structured products and noncorporate credit.” Noncorporate credit includes bonds such as foreign sovereigns and supranationals that issue in U.S. dollars.
“Underpinning this approach is allowing a manager greater flexibility in investing around a benchmark, rather than being narrowly constrained by the benchmark itself. It is going to where the markets are least efficient in the same way that core-plus managers seek to add value by using more flexibility than core managers,” Hunt said.
The second approach is to look for alpha-generating opportunities within the corporate credit universe, such as smaller issuers. “Many of the inefficiencies lie in the smaller issuers,” Hunt said. That sector “can diversify your credit exposure and also help capture alpha opportunities,” he said. Standard bond indexes have limited exposure to these small issuers, so Allspring created the Small Issuer Long Credit Index or SILC, with Bloomberg, which aims to reduce the issuer concentration risk in LDI portfolios caused by traditional indexes.
INTEREST IN ETFS CONTINUES
Plan sponsors’ use of fixed-income exchange-traded funds for the hedged portfolio has been a trend in recent years, said Giordano at S&P DJI. “Fixed-income ETFs lagged equity ETFs, but starting in 2019, [and] especially during the COVID disruption, we saw significant inflows into fixed-income ETFs.”
“During the most volatile times, ETFs have provided price transparency that some users did not get in the over-the-counter market. Both strategically and tactically, sponsors may use bond ETFs when looking to rebalance and execute more quickly. It’s easy for them to control and adjust their exposure, as opposed to having to trade numerous securities or deal with another asset manager who can have a two-or three-day lag for a liquidation order,” he said. Giordano noted another reason fixed income ETFs have found increased acceptance: the Federal Reserve. “The Fed announced that they were going to use 16 different bond ETFs to provide support to fixed income markets,” in response to the COVID-19 crisis in 2020, he said.
A COMPLETION SOLUTION
Plans are also turning to managers for completion management, according to Thompson at Reams Asset Management. “Someone has to work with the plan as the quarterback, making the calls and drawing from other managers,” he said. The firm works with each plan to identify and execute trigger points for derisking while overseeing the overall fixed-income portfolio. “We help sponsors on the hedge part of the portfolio to find their way across the goal line, so to speak.”
The quarterbacking theme resonates when considering the liability-based portfolio. Kennelly said State Street Global Advisors is “in the completion business effectively across all our pension clients, particularly around managing hedge ratio targets. We are also quarterbacking across multiple managers for our clients.” To do this, his team measures the risk profile of each manager against the liability risk profile of the plan itself. “Where there are gaps in an exposure, whether it be duration, yield curve or spread, we are completing on that,” he said.
He further noted that completion can mean deploying synthetic investment strategies, although some clients may deem them too complex. “The less well-funded plans [can] target a hedge ratio through more capital-efficient strategies, [such as] using Treasury futures as an overlay to achieve a higher hedge ratio, allowing them to free up capital for growth needs.” There’s also a role for alpha-generating, diversified investments for the hedged portfolio. “Alpha within fixed income has certainly been — while I don’t want to say it’s easy to achieve — a better opportunity set than in the equity space,” Kennelly added.
“As plans get better funded, get closer to the hibernation stage and fixed income is more prominent, they’re really starting to work with us and others to refine their fixed-income LDI portfolio. Completion, or hedge-ratio management, is the topic of the day,” Kennelly said.
USE OF CUSTOM BENCHMARKS RISES
There’s been an increased interest by pension plans in custom benchmarks versus the off-the-shelf fixed-income benchmarks of the past.
“The increase in customization is getting to a point where sponsors, and even consultants, are coming to us to get more specific and granular details around benchmarks that they’re using to measure performance of their plans,” said Giordano. S&P DJI can build custom benchmarks out of existing benchmarks, he said. “We have a full suite of traditional building blocks for LDI: the S&P U.S. Government Bond Index, corporate bond indices and indices that combine the two. Many are broken into specific maturity and credit buckets with more inquiries about specific durations. Part of the customization process is to factor these into an LDI benchmark.”
A critical reason for custom benchmarks now is “the multidecade degradation of credit quality in markets as defined by flagship indices,” said Thompson of Reams Asset Management. “Corporate America is more willing to operate with a more levered balance sheet and lower credit ratings than in decades past. Thirty years ago, there were around 15 AAA companies and now there are just a handful. Same thing goes with AA’s.” That has resulted in a poor mapping of the broad market benchmark to pension liabilities, he said. Using the long-credit index as the benchmark would lead to “a rather large mismatch of basis risk because of the credit degradation.” (See chart on decline in credit quality.)
“Plans need customization to get the credit quality of the benchmark to match the credit quality of the liability,” he said. “A custom benchmark will match the cash flow profile of the defined benefit plan and can also pinpoint the credit quality.”
An even more advanced step is direct liability management, which is “the very purest construct,” said Thompson. It “dispenses with the public benchmark altogether. That’s when the plan sponsor says, ‘Forget public benchmarks. I’m going to give you my liability curve, cash flows and the discount rates, and that’s your benchmark.’” Just a handful of plan sponsors have adopted this approach so far, but he said he expects interest in direct liability management to grow.
AN AVANT-GARDE ESG APPROACH
Though integration of environmental, social and governance factors has been adopted by many asset managers, what is largely underappreciated is the intersection of ESG and the LDI glidepath.
“By making your asset allocation shift from equity to credit through the LDI glidepath, you’re actually increasing your carbon footprint,” said Hunt at Allspring Global Investments. “The reason is the S&P 500 Index and other equity indices have a light carbon footprint compared to the standard benchmarks in the long-credit space, which include a lot more carbon-heavy industries like utilities. This could potentially impact the ESG score of the parent company.” The plan sponsor’s enterprise-wide carbon footprint would include the implied carbon footprint of its pension investments, along with all its business activities, he noted. (See graph below.)
“Our solution is a climate transition credit portfolio that is a specific form of ESG,” Hunt said. “It has at least 30% lighter carbon intensity than the standard long-credit benchmark, and it’s on a path to net-zero emissions by 2050 while also capturing alpha potential by targeting investment in [the] companies that are best placed to succeed in a world of climate transition. At a stroke, it helps to fix this problem I’ve just described.” While this is an avant-garde area for LDI, it could gain attention as more asset owners get familiar with the implications of an improved carbon footprint and portfolio positioning, he said.