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LDI: No Rain, No Rainbow

An Institutional Investor Sponsored Report

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To help raise their funded-status ratios after a stormy period, corporate defined-benefit plan sponsors are considering near-term direct contributions. Proposed changes to the corporate tax code and other issues could make the timing opportune.

Implemented by most corporate defined-benefit pension plans, liability-driven investing (LDI) manages current assets to match future liabilities. Typically, a plan’s assets are separated into return-seeking and liability-hedging allocations, and a glide path is established to de-risk the portfolio—reallocating return-seeking assets, usually equities, to liability-hedging fixed income strategies. Such reallocations are triggered as the plan achieves predetermined levels of funded status—the percentage of future liabilities the plan is able to cover. The Milliman 100 Pension Funding Index, a measure of the funded status of the 100 largest pension funds, stood at 81.5 percent at the end of February 2017. A decade ago, the average was 105.3 percent—a surplus that has been eroded by low interest rates and volatile equity markets.

Many plans have paused de-risking following the most recent drawdown in funded ratios since the end of 2013, when they were on average around 88 percent. “Plans with de-risking-only glide paths still need to wait until funded ratios get back to those prior peaks, before they resume de-risking,” says Amy Morse, Director of Pension Strategies at Wellington Management. This could require discount rates to increase about 25 bps and equity returns in the mid-single digits.

Outside of the markets, plans can improve funded ratios through company contributions, and this could be an opportune time. “There could be reasons for plans to consider making near-term contributions,” says Bill Cole, Fixed Income Investment Director at Wellington Management. If corporate tax rates go lower, a plan sponsor could write off deductions at the previously higher tax rate if made before new legislation is enacted. Another incentive is to mitigate premium increases to the Pension Benefit Guaranty Corporation, which provides pension liability insurance.

Another consideration, which could further encourage contributions, is the future availability of long-duration, high-quality corporate bonds. “The supply could be reduced in the coming years,” says Cole. If corporate taxes are lowered, the ability to write off interest is not as valuable. There also could be an opportunity for issuers to repatriate overseas cash at a reduced rate, especially technology and pharmaceutical companies. Moving their substantial cash holdings to the U.S. could dampen future investment grade issuance.

Investment Strategies
LDI requires a delicate balance of allocations to growth assets and income assets, and thoughtful management of each. On the return-seeking side of the portfolio, plans are looking to alternative strategies to reduce overall risk and generate more balanced returns across a variety of economic environments. On the liability-hedging side, the question is how precisely to match the liability cash flow profile. “Plans need to target a few key risks—credit risk, interest rate risk, and curve risk,” says Cole, noting that most plans can do this by blending standard market indices to reflect their liability profiles. “A little customization can go a long way, but too much can lead to issuer concentration, less liquidity, more complexity, and increased cost,” he says.

Furthermore, many plans remain under-hedged relative to their liabilities. De-risking is on hold as sponsors wait for rates, and thus funding ratios, to rise. “There is a significant cost to this if rates don’t rise significantly,” says Morse. “Plans can respond to short-term rate movements by incrementally lengthening duration to protect the resulting funded ratio gains,” she says. Otherwise, if rates don’t continue to march upward, gains could erode over time as the liability out-yields the plan’s liability-hedging assets.

“Systematic, predetermined glide path allocations make sense,” says Cole. It works best when strategies have been well thought out, well communicated, and well vetted by an investment staff, so everyone knows the plan of action through different market environments.
—Howard Moore

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