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.”
Liability-Driven Investing & Risk Mitigation Webinar
Tune into an audio webinar by our panel of experts who share the latest techniques for managing plans across all stages of the glide path. From defensive equity strategies, diversified asset exposure, and active – passive approaches all the way to completion management and pension risk transfer, this webinar will give you practical insights and solutions going into next year.
Featuring
Andy Hunt, FIA, CFA
Head of Fixed Income Solutions I Multi-Asset Solutions
Allspring Global Investments
Todd Thompson, CFA
Managing Director and Portfolio Manager
Reams Asset Management
Jason Giordano
Director, Fixed Income Indices
S&P Dow Jones Indices
Thomas J. Kennelly, III
Managing Director – Senior Investment Strategist, Investment Solutions Group
State Street Global Advisors
Wednesday, December 1, 2021
2:00 p.m. ET
Read: State Street Quarterly DB Insights: What the Fed’s Recent Commentary Means for Defined Benefit Plans
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.)
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.
Thomas Kennelly III
State Street Global Advisors
“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.”
Read: Indexing Liquid Alternatives
“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.”
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?”
A lot of current and emerging best practices are moving the LDI ball forward. There is a lot of money in motion as the glidepath progresses from equity to long-duration fixed income.
Andy Hunt
Allspring Global Investments
“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…
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