An all-weather solution
Liability-driven investing by U.S. corporate pension plans has shown its worth by preserving plans’ funded status, even through the current economic turmoil and market volatility. Plans that have pursued LDI — managing assets to ensure they can meet future pension liabilities — have seen their funded levels increase, given strong equity market returns in the prior two years and the decrease in liabilities from the higher rates this year. It has put them in a better position to consider offloading pension risk from their balance sheet, such as via a pension risk transfer.
Despite the improved funded profile of corporate pensions, plan sponsors are reacting to the Federal Reserve’s interest rate stance by carefully reevaluating their current LDI techniques and their impact on the absolute returns of their portfolios, which typically have significant allocation to long bonds. U.S. plan sponsors have also evaluated their portfolio strategies to see if there are any lessons to be learned from the U.K. bond market panic in October. That situation was triggered by U.K. pension funds’ use of derivatives, part of their LDI strategy that backfired due to an unprecedented spike in the yields of British gilts, U.K. government bonds.
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A positive trajectory
“Plans in general have had a good year to date, driven by rising discount rates, and LDI has performed as expected,” said Thomas J. Kennelly III, senior investment strategist in the Investment Solutions Group at State Street Global Advisors.
When reviewing plans segmented by profile and funded status, “less well-funded plans have benefited this year because their liabilities have gone down faster than their assets, as they generally have lower hedge ratios,” he said. But well-funded clients also did well, “as their funded status has remained very stable.” The firm is focused on surplus management and hibernation solutions for both types of plans.
The recent U.K. crisis holds lessons for U.S. plan sponsors, even though their LDI practices differ in some respects, Kennelly said. “Most notable [in the U.S.] is less use of derivatives and greater use of corporates and Treasuries. Where derivatives are used, the key factor is how much leverage is employed and how well collateralized are you? We prefer to err on the conservative side.” His takeaway from London for U.S. sponsors: “Understanding the total picture [of your investments] from a governance, liquidity and risk-management perspective is the biggest lesson learned.”
Looking ahead, as plan sponsors navigate the peaks and valleys of the markets across asset classes, “there could be a lot of noise that might not be impactful when you look at overall funded status,” he advised. The reason is the strength of the LDI approach. “Yields are up, equities are down, volatility is higher, but a well-funded, hibernating pension plan has slept well at night.”
Need to improve agility
“Is there a risk of LDI contagion from London, or that the same problems could happen here? The answer is no,” said Andy Hunt, CFA, FIA, head of fixed income solutions, systematic edge investment solutions, Allspring Global Investments.
U.K. corporate pensions use a very different LDI strategy than U.S. pensions do, with the former adopting far greater use of leverage, exposing them to margin calls when prices drop quickly, he explained. U.K. plans tend to offer inflation-adjusted pensions, and for hedging efficiency they have turned to derivatives to help maximize exposure to inflation-linked bonds. These exposures were in collective funds, and the collateral arrangements supporting the derivatives were impacted during the recent market storm in London, Hunt explained. He added that use of derivatives is much less common with LDI in the U.S. (See chart below)
- Manage derivatives alongside other assets. “Keep your derivatives close to other assets in your portfolio, so they don’t have the observed collateral challenges,” Hunt said. “Operationally, if you use derivatives, do so with managers holding other assets of yours so it is easy to move money to where liquidity is needed during a crisis.”
- Be prepared. “The events in London weren’t unwelcome [because liabilities went down]. They also weren’t unpredictable. But their speed caught people by surprise,” Hunt said. U.S. pension plans should conduct event-risk analysis. “Think through scenarios so that should they happen, it’s not a question of what to do, and the focus can just be on making things happen.”
- Improve agility of decision-making. “Markets can move quickly. The speed of the pension plan’s [decision-making and reaction] needs to be able to match the speed of the markets,” Hunt said. To improve agility, plans can “ensure there is adequate delegated authority to enable action without having to solicit meetings from a fiduciary committee.”
Liquidity to the fore
“LDI strategies have behaved as they were supposed to this year. Yield increases have outpaced the impact of the negative equity returns. Pension funding has improved through all the [market moves],” said David Phillips, CFA, ASA, EA, director of liability-driven investment strategies at Parametric Portfolio Associates.
He pointed to the importance of rising rates for improved funded levels. “Rising rates generally aren’t harmful to pension plans because their liabilities fall.” The liabilities are based on long-term bond yields and decrease when yields — which move with rates — rise.
The U.K. bond market crisis was a liquidity crisis, Phillips pointed out, adding that the lesson for U.S. pension plans is to have a prudent liquidity strategy. While U.K. corporate pensions used high leverage and ended up facing unprecedented liquidity needs to cover margin calls, that situation is unlikely to occur here, as U.S. pensions use less leverage and invest in a deeper bond market. However, U.S. pensions should reevaluate their liquidity strategies to ensure they are reliable across all market scenarios.
“First and foremost, you need a larger cash buffer if there are derivatives used in LDI,” said Richard Fong, CFA, director of investment strategy at Parametric. Plans “also need to construct and formalize a liquidity waterfall. This is a playbook through which you are able to obtain liquidity if you run out of cash,” he said, referencing a strategy to rank order assets to liquidate should the need arise.
To build a robust waterfall, Fong recommended that pension plans take a customized approach, “which includes expanding an overlay program beyond just the liability [matching] assets. If you build the waterfall to include other assets, you significantly reduce the liquidity constraints and problems that materialized in the U.K.”
Improved situation to derisk
The improved funded status of many pension plans, along with the prospect of facing continued market uncertainty from slowing growth and rising inflation, has led to “an environment where plan sponsors are looking at taking some risks off the table. The value proposition of pension risk transfer is its ability to help plan sponsors derisk,” said George Palms, CFA, president at Legal & General Retirement America.
Plans clearly understand this value proposition, he said, as their strong funded status allows them to transfer some or all of their pension obligations to an insurance company by purchasing a group annuity contract. The derisking move also allows companies to focus on their core business and to save on Pension Benefit Guaranty Corporation premiums, which continue to increase, Palms added.
“We expect that this year will be the largest ever U.S. PRT market, which we estimate at around $55 billion,” he said, surpassing the record of $38 billion in 2021. “This huge surge in activity is [driven] first and foremost by plan sponsors’ improved funded status. They have more optionality around potentially doing a PRT transaction and moving some of those liabilities to an insurer.”
The PRT trend is only likely to accelerate, according to Palms, as more plans complete their own successful initial transactions or watch others do so. “It’s built a crescendo of market growth that is going to continue into the next 10 to 20 years,” he said.
A Finer Calibration
When it comes to LDI, the question is not why but how. While corporate pension funds that follow LDI strategies have improved their funded status, they are evaluating or revisiting their asset allocation — particularly in light of the market volatility and rising interest rates — to ensure they are best meeting their plan objectives. That includes exploring customization, adding derivatives where appropriate and bringing in environmental, social and governance factors to enhance overall risk management — all of which varies depending on where plans are in their funded status journey.
The custom route
“Customization is always key. Whether it’s a traditional plan or a cash-balance plan, LDI strategies should be customized to each plan’s unique set of characteristics,” said Phillips at Parametric Portfolio Associates. This becomes more urgent as plans’ funding situation improves because they move down their glidepath — the mix of investments that shift over time — toward holding more fixed income, he noted. Customization through curve matching and glidepath management can offer pension funds a more precise matching of assets and liabilities, as well as liquidity management, while they move closer to plan termination, he said.
Customization can be useful across many pension plan objectives, said Fong, Phillips’ colleague at Parametric. For instance, “if you have an underfunded plan that still has a low hedge ratio, you might need a hedge-ratio extension. If you are a plan that is close to a pension risk transfer or hibernation, then you’re going to focus on liquidity or building a custom corporate bond portfolio. In all these instances, you need customization, preferably in a separately managed account, for your unique circumstance.”
A core-satellite view
State Street Global Advisors believes in the core-satellite approach to LDI, said Kennelly. The firm deploys this portfolio construction technique, which consists of an index-like core and an actively managed satellite, both for the liability-hedging portfolio and the growth- or risk-assets portfolio.
“The core LDI portfolio targets a duration and hedge ratio with corporates and U.S. Treasuries,” Kennelly said, while in the satellite portfolio, active managers provide alpha or the potential for market-beating returns. “Customizing across different durations, yield curve, sector and credit quality has always been what we offer.”
Each client’s funded status drives the composition of the growth portfolio, Kennelly added. For underfunded plans that need return and diversification, “their growth portfolio in addition to equities will potentially have private assets, real estate and some opportunistic managers.” For well-funded plans far along their glidepath, the growth portfolio is constructed with a tight focus on risk, Kennelly said.
In addition, asset classes with hybrid characteristics can be appropriate, since they have both equity and credit correlations, such as high-yield bonds, emerging market debt and bank loans. “We gain our exposure through active managers who can move across these asset classes.”
State Street Global Advisors is also seeing increasing interest in derivatives management, which offers greater capital efficiency and fewer disruptions to physical assets. “The completion manager repositions the bond futures portfolio, mindful of collateral needs,” Kennelly said. As plans move down the glidepath to full funded status, an LDI program aimed at minimizing portfolio risks can be further customized by completion mandates. (See chart below)
Addressing inflation risks
“U.S. pension plans are widely regarded as having nominal liabilities, but that’s not quite the case,” said Allspring’s Hunt. “We need to remember that final average salary plans have an inflation component through wage growth of active participants.” For that reason, pension plans need to diversify their growth portfolio to include inflation-hedging assets, such as commodities and other real assets.
Read: Doing LDI Well in 2023
Derivatives have value for both the growth and liability-hedging portfolio, Hunt added. “Derivatives are great tools to help both sides of the pension plan balance sheet — that is, both [for] hedging liability risks and shaping return distributions,” he said. “Yet most U.S. pension plans don’t use them at all.”
“Derivatives can be particularly useful for mature plans,” Hunt said, as they face asymmetric risk of relatively modest upside benefits when overfunded but much more financial pain if underfunded. Derivatives can alleviate this asymmetry as plans can “sell excessive upside to help buy protection — i.e., insurance — against downside.” While derivatives need close oversight, and the lessons from London outlined earlier are important, the pension fund industry should embrace them more for improved investment efficiency, Hunt said.
Aligning with ESG
Although many corporate plan sponsors’ mission statements emphasize the importance of ESG investing, their portfolios are often not yet aligned with this mission, said Hunt at Allspring. One of the main challenges is that “as plans invest in LDI bonds, [many] long credit bonds are carbon-intensive,” he said, referencing the significant long-dated bond issuance by utility, basic materials and energy companies.
“The good news is you can invest around this [problem] successfully,” Hunt said, noting that Allspring offers a climate-transition credit strategy that is aligned with the Paris Agreement to move toward a global net-zero emissions economy. Under the strategy, “we buy a portfolio that aims to outperform the market benchmark but does so in such a way that it delivers a significantly better carbon footprint. It invests in tomorrow’s low-carbon emitters and those firms who can successfully make the transition to a low-carbon future economy.” He said he expects the ESG lens to continue to grow for LDI over the next five years.
The booming PRT market
Moving pension obligations off the balance sheet is top of mind for many corporate plans that have improved funded status and have a desire to avoid the continued uncertainty of complex and volatile markets. But what type of pension risk transfer should they pursue? A buyout or buy-in, a full or partial plan termination, or a lump-sum distribution to participants?
Over the past 10 years, both the number of participating insurers offering PRT and the types of transactions have expanded. “These new competitors have brought additional capacity and helped the market grow and develop over time,” said Palms at Legal & General Retirement America. The deals have also developed beyond the traditional plan-termination buyout that prevailed prior to 2012.
Read: PRT Monitors
Partial buyouts, or lift-outs, where a portion of plan-participant pension obligations — typically for retirees — are lifted out and transferred to an insurer via a group annuity, have seen an increase in activity over the last decade, said Palms. LGRA has also seen an increase in buy-ins, which are helping to drive overall PRT market growth, he added. These are similar to buyouts, but “in a buy-in, the sponsor retains the fiduciary and administrative responsibility for the retirees, [and] the insurer effectively takes over the investment and longevity risk,” he said.
“Buy-ins are also gaining traction around plan terminations, where they can be used by the plan sponsor over a shorter period of time to effectively lock in their pricing,” Palms added. Yet he does not see the growth in buy-ins leading to their becoming the predominant transaction in the U.S., as they are in the U.K, he said.
Other drivers of growth
The overall growth in the PRT market is also being driven by insurers’ use of reinsurance, Palms said, where the insurance company works with reinsurance providers to cover additional risks. “Reinsurance increases the amount of capacity in the PRT marketplace. As more insurers use reinsurance to expand their capacity and manage risk, we expect increased competition in terms of the number of insurers bidding on deals and in pricing to continue,” Palms said.
The growth in the PRT market is unlikely to slow any time soon — from large deals over $1 billion to smaller deals under this threshold, Palms said. “The rapid growth of the PRT market has only scratched the surface. The market opportunity in U.S. corporate defined benefit plans is about $3.2 trillion.” (See graph below)
Look beyond price
In the current promising PRT environment, “we are seeing repeat transactions from clients,” said Kennelly at State Street Global Advisors. Competition between insurers in the PRT market has brought down transaction prices, but “companies need to be mindful of who those players are, understand their pricing and credit quality and not [choose] the best price to the detriment of participants, from an insurance carrier-credit concern perspective,” he advised.
“Every plan has a different path toward pension risk transfer. Everything [must be] in alignment as we move along [the path],” said Phillips, adding that Parametric Portfolio Associates uses a customized approach for each plan undertaking a PRT. For instance, “we manage higher-quality corporate bonds that an insurance company would prefer in a transaction. We [also] facilitate PRTs [by] matching cash flows leading up to the transfer.”
“The most important thing plans can do before PRT is to do their homework,” Phillips advised. “They need to understand which liabilities are being transferred and that the assets have been appropriately invested for settlement,” he said. “That requires customization.”
Strategy that improves outcomes
While the corporate pension plan market is a mature market, there is a lot of money in motion, both in the growth portfolio and the hedging portfolio, as plans move down the glidepath and get closer to full funded status. Some plans are aimed at improving their risk-management practices with LDI, while others are pursuing derisking by offloading their pension obligations via a pension risk transfer.
This is an exciting time to create better LDI solutions that address specific plan sponsor needs, said Allspring’s Hunt, and he is putting his efforts into “designing new strategies that complement what most LDI portfolios have in place. LDI can be done differently — and better.”
Allspring is differentiating itself with new portfolio offerings, such as its climate-transition strategies, as well as taking a more diversified approach to fixed income. For instance, “smaller issuers make up half the market capitalization, but they amount to 90% of the issuers,” said Hunt. “We believe they are underrepresented in most portfolios and are a good alpha opportunity. We access these [smaller] opportunities through our small-issuer long-credit strategy, with appropriate credit research coverage.”
Being liability-aware
State Street Global Advisors is seeing more activity in what it terms liability-aware investing, said Kennelly. It is designed for organizations that are not corporate DB plans and are not governed by the same accounting rules yet face similar long-tailed cash flow needs. Examples are Voluntary Employees’ Beneficiary Association (VEBA) plans and nuclear decommissioning trusts. “Their portfolios are managed so they are liability-aware from a cash flow and exposure standpoint,” he said.
In terms of corporate DB plans, “as pensions have become better funded, the focus on LDI has increased. The precision of LDI solutions has improved,” Kennelly added. Corporate plans need to carefully select their LDI partner. “Our philosophy around LDI is about more than just the products. It is the asset allocation oversight, manager oversight, trading, portfolio positioning around liabilities, liquidity management and risk management.” The core-satellite approach at State Street Global Advisors is important. “Building the satellite for excess returns and to provide diversification is also important. [Core-satellite] has to work in tandem,” said Kennelly. The breadth of investment capabilities — and experience — differentiate a successful manager, he said. “Being able to navigate through the challenges that we’re going to face in the next two years is very important. Price is not the only factor: So is value for money.”
A tailored approach
The rise in interest rates is narrowing the funding gap as liabilities shrink, said Fong at Parametric Portfolio Associates, giving pension plans the opportunity to add to their hedge ratio. “For plans that already have hedging programs in place, customization can refine and lock down any residual risks.”
Offering a broader toolkit of capabilities distinguishes LDI managers in an otherwise mature market, Fong said. “What differentiates a successful LDI manager is one who can offer comprehensive customization. That includes the ability to manage across the glidepath, asset classes and also instrument types.”
“LDI is everything,” said his colleague Phillips. “Your investments pay off liabilities in the future. So it is important to think of the big picture. Recognize that plans are better funded despite volatile markets. Understand where you are going to get liquidity.” Pension plans and their asset managers need to be able to act in a timely manner to navigate the current volatile markets, with the need for improved control and responsiveness typically requiring customization. “Hire an LDI manager with expertise and experience, and who can deliver innovative and customized solutions for managing a pension plan throughout each stage,” Phillips said.
PRT servicing that delivers
In today’s competitive PRT market, which has over 20 insurance providers, a real differentiator is an insurer’s approach to servicing participants, said Palms at LGRA. “We’ve invested in creating what we think is the market-leading service infrastructure,” he said, adding that a key feature is a high level of customization that may be needed by some corporate plans. For example, for an international company that paid employees by wire transfer, LGRA created the capability to continue paying annuitants through wires, ensuring a smooth transition from sponsor to insurer in servicing the plan’s participants.
“The ability to be tailored to what the client values and needs is important,” Palms said. Another example is pension plan benefits that include cost of living adjustments, or COLAs, which many insurers avoid because of their complex features. “We support pricing those and do those transactions.”
With LGRA’s strong focus on participant servicing as a critical aspect of a successful PRT, its customer service experience surveys with call-service representatives has awarded the firm 4.95 out of five stars. “Our focus on service is something we invest in, that we pride ourselves in and that our clients really value.”