Investment veterans aren’t strangers to volatility – they’ve been through expansions, recessions, the 2008–’09 financial crisis, and a now lengthy ongoing period of “lower for longer” yields on fixed income securities. However, no curveball caught investors quite as unexpectedly as the one-two combo of this year’s pandemic and economic crisis. Most investors will agree that the impact wasn’t as bad as it might have been, but there are unquestionably lessons to be learned and applied as investors look to 2021 and beyond. This report explores key takeaways from the pandemic, and how they can be put to good use.
Keith McDonagh and his colleagues at MassMutual Life Insurance Company (MassMutual) are in the business of providing financial and risk management solutions for institutions – and, as you might imagine, that business has seen customers’ needs increase in a wildly unpredictable 2020. McDonagh is the Head of MassMutual’s Institutional Solutions businesses, which involve the design and delivery of solutions for pension liabilities, retirement solutions, financial returns, protection needs, and increased employee benefit costs. The solutions include pension risk transfer, bank-owned life insurance and corporate-owned life insurance (BOLI and COLI), stable value investments, mutual fund investments, funding agreement backed notes, and guaranteed interest contracts. II recently spoke with McDonagh about his observations while interacting with investors in this tumultuous year, and how the lessons learned can be applied moving forward.
What are you hearing in terms of the challenges that your institutional clients have faced and continue to face as a result of the pandemic, economic stress, and geopolitical uncertainty?
Keith McDonagh: When we started the year, no one would have been able to predict the course it would take. As the year progressed, if you asked the same people about the future, their perspective would change with each passing month. There has been uncertainty and volatility not only with the pandemic, but in terms of interest rates, equity markets, employment, the economy, GDP, trade policies and/or competition between nations, the upcoming general election – it’s an almost endless list, with uncertain, volatile, and unpredictable being its three most common adjectives.
In other words, a time when investors are asking themselves a lot more questions than they typically would.
McDonagh: Right, and that’s another long list: How do I manage the environment to achieve my goals? How can I be better prepared? How can I be more flexible? How can I check and adjust, or pivot, as needed to meet my expectations? How do I make sure I have enough liquidity to meet what could be changes in consumer demand or consumer behavior? And enough liquidity to take advantage of opportunities that may occur due to this volatility? How can I achieve adequate yield in a low interest rate environment? There was a time this year when credit spreads widened measurably and then came back in, and equity markets fell and came back, so how can I achieve my goals within my stated investment philosophy?
At MassMutual, we like to say, “You can’t predict, you can prepare.” And we also like to say, “Think long term, not just short term.” What we mean when we say either is that asset owners and managers have to excel at managing risk – whether those risks are related to changes in valuations, assets and liabilities, or benefit funding – and the volatility that risk could create on their income statement and balance sheet, or at a time when they require funding to meet a need. It’s a matter of having the right arrows in the quiver to match assets and liabilities within the risk tolerances and strategic goals that have been set.
Have you seen an uptick in the number of institutions reaching out to you with a sense of urgency?
McDonagh: The dynamics have been interesting in that regard. In the first month of the pandemic, all the focus was short term. That’s where we saw the huge focus on liquidity, and as we all recall, the bond markets seized for a couple weeks as we got into late March, early April. It was also a period where those companies who may have been contemplating large transactions hit the pause button while they surveyed the environment, because they didn’t know what conditions were coming and what they might need – and it was difficult to focus on all the details of a large transaction with everything that was going on.
The second dynamic we saw in that timeframe was a bit of a flight to certainty. For example, the demand for solutions like stable value in those first couple months increased dramatically. People were pulling out of equity solutions and moving into more stable solutions, and there’s a correlation between that trend and investors trying to position and see what’s happening before making broader risk-on bets.
Was there increased decision making in terms of some of the strategies that might apply to pensions? Maybe more conversations about LDI?
McDonagh: There were, and I’ll frame this answer in a six-month window starting in March, because I think it’s quite insightful. In the early days, those sponsors who had engaged LDI going into the crisis were very happy, because their funded status was more stable. Those who had only been dabbling in it, or thought about it but hadn’t executed, suddenly showed a lot more interest in what LDI was about as they saw the impact of unfolding events. So, we were engaged in conversations about how LDI works, clearly, but also about some of the investment solutions, say, in a long-term bond fund, that can be used in an LDI context.
There was a second thing we saw early in the crisis. The pension risk transfer market has been growing each of the past 10 years or so, and the pipeline was quite healthy in the first quarter. In the early months of the crisis, plans that were looking at retiree carve-out transactions paused given the economic conditions. If you look at market data for the second quarter, you’ll see that activity slowed, and the transactions that were executed tended to be plan terminations, because they were already scheduled.
the companies wanted to hold cash. Second, management bandwidth – they were worried about other things.
A third dynamic is that several of those transactions that had paused came back to market in the latter months of the year. So, as the equity markets rebounded, for example, pensions plans that still have heavy equity allocations saw their funding status improved. That’s an example, but as time passed and economic conditions stabilized, management could go back to focusing on some of the risk management plans they had in place. Not back to normal, but a significant rebound from what you would have seen in, say, April, May, June, and July.
That seems to speak to a realization that they really needed to execute on things they’d been planning – a return to some sense of normalcy.<
McDonagh: It’s that feeling of “I should have paid more attention to these long-term planning considerations when times were good, so now I’m going to put it on my project plan as one of the things I need to focus on going forward.”
People talk about business continuity planning, but what we’re talking about is almost investment and financial continuity planning – you need to have a plan for how you’re going to continue on the path to achieving your long-term goals, even when things are disrupted.<
McDonagh: We are a mutual company at our core, with many customers who have been with us for decades. That is embedded in how we think about things, and the view I give our institutional clients, specifically, is that while you clearly need to think about the quarters and the year that you’re in, if you want to address long-term health, think in terms of years and decades. As many of us learned in business school, a successful business positions itself for success through various economic cycles and environments. Undoubtedly, there will be expansion years and contraction years, and you should position your business strategy and the products and services you offer accordingly, along with how you interact with customers and changes in consumer behavior. Asset owners should be applying those same principles to investment management and risk management, thinking both long term and short term. If you don’t, you could get imbalanced.
Consistent with its decades serving the retirement needs of clients, MassMutual is an expert provider in the defined contribution (DC) investment-only space. It makes sense, because investing for retirement requires a certain DNA and investment philosophy. The entire MassMutual Investments platform is centered around retirement-oriented outcomes, which the firm feels is best pursued by embracing a multi-manager philosophy.
Greater potential for more consistent, risk-sensitive, long-term performance. This is especially important for helping retirement investors minimize the behavioral biases that often lead to sub-optimal investment decisions. Staying appropriately invested throughout market cycles enhances their ability to meet retirement needs.
Sophisticated and rigorous manager selection and monitoring processes. An emphasis on risk management helps alleviate concerns about manager performance.
Portfolio construction with specific purposes, allowing for outcomes that are more closely aligned with investors’ needs.
Access to a greater range of managers without overwhelming plan participants with options. That’s important, because data suggests that 401(k) plan participants suffer from “choice overload.”
Several studies have shown that the diversification benefits from multi-manager funds help investors meet their accumulation needs. While diversification doesn’t protect against loss in a declining market, the expected portfolio value at the end of the investment horizon (terminal wealth) is paramount – not the ups and downs in portfolio returns over the investment period. The chart below exhibits the reduction in the standard deviation of terminal wealth in portfolios in specific asset classes when additional managers are added. The lower the standard deviation, the lower the risk associated with having an unexpected shortfall heading into retirement.
For all equity asset classes measured, the standard deviation of terminal wealth fell significantly by adding managers to the portfolio. The most risk control from manager diversification is gained in portfolios with two to three managers. The incremental benefit of adding managers beyond this number decreases as the number of managers rises.
Building the multi-manager portfolio
MassMutual selects “best in class” asset managers in their respective investment style with the goal of identifying managers that can consistently deliver positive, long-term results while limiting volatility. The best-of-the-best are determined through rigorous quantitative and qualitative screening, ongoing interviews with the target firm’s management and professional staff, and assessments of the firm’s compliance organization, policies and procedures, code of ethics and regulatory history. This process includes an evaluation of the sub-advisors risk management, compliance and operations functions.
In building its multi-manager portfolios, MassMutual selects managers that invest within the same asset class but with unique and complementary styles. As a result of differentiating views on stock selection and portfolio construction, these managers will typically have minimal overlap in holdings and low correlation of excess returns.
Here are a few examples of how pairing managers in this way allows portfolios to benefit:
- Style diversification: Managers with different styles diversify the sources of returns.
- Larger opportunity set: Fund holdings are likely to be diversified across a wider selection of securities, with exposure to a broader range of holdings characteristics.
- Business risk diversification: Many factors may influence the performance of a single manager including turnover, investment process drift, change in ownership structure, etc. Engaging multiple managers diversifies these risks.
- Allocation of capital across managers within the funds is strategic and determined through a disciplined process that incorporates both quantitative and qualitative elements.
- Historical returns for each manager are examined alongside its complementary manager pairing, and in a stand-alone capacity.
- The process examines risk and return in various market regimes recognizing that a manager’s style varies in efficacy throughout market cycles and reacts differently to positive and negative market events.
- Qualitatively, MassMutual incorporates deep insight into the manager’s strategy and style generated by its dedicated Manager Research Team.
- Combining these two additive portfolio construction approaches has helped MassMutual achieve more durable and persistent returns on behalf of its clients.
As Keith McDonagh noted in his interview above, the flight to certainty triggered by extreme volatility earlier this year was accompanied by a surge in demand for stable value solutions. As part of its commitment to meet the long-term needs of retirement plan participants, MassMutual Investments is a leader in stable value funds and wraps. Here’s a quick look at how investors can benefit from stable value.
- Stable value is the conservative fixed income option offered in a DC plan line up designed to preserve principal for the participant saving for retirement. These solutions are purpose-built to weather volatility and are comprised of a portfolio of fixed income investments managed by an investment manager or insurance company.
- An insurance company provides a stable value wrap on the portfolio of fixed income assets. This wrap is an insurance guarantee to protect the principal and allow participants to transact in and out of that account at book value. The stable value wrap also provides a smoothing of the crediting rates, so the performance of the fixed income assets passes through to the participants over time. The goals are a stable return and asset preservation.
- From the plan sponsor’s perspective, the assets are always available at market value should a sponsor choose to move to another provider. If market value is below book value, any book value payout comes over a period of time.
- MassMutual is a leading provider of stable value solutions for both retirement plans and asset managers. “On an investment only basis, we offer stable value solutions across general account, separate account and other structures,” says McDonagh. “We also provide solutions for asset managers who offer stable value funds, with insurers providing the wraps. In those cases, the asset manager selects the wrap provider.”
- It’s a competitive landscape where MassMutual ranks among the largest providers based “upon our credit quality, our expertise and knowledge in the space, and our servicing of these portfolios” says McDonagh.
Stable value has been strong growth market for MassMutual and is a continued focus moving forward. MassMutual is a 170-year-old company that has been through every economic and market scenario over that timeframe. “We’re one of the highest rated and most financially strong insurers,” says McDonagh. “Our fixed income DNA has evolved over multiple market cycles, and we have deep expertise in the stable value space.”
Very few companies would list “managing a pension plan” among their core business competencies. Pension plans are a benefit developed for the employees you’ve hired to make your company successful. The pension plan was not your company’s core reason to exist. To run a successful business, companies seek to have a well-managed pension plan and related liabilities so that the company can focus on what it does best.
Fortunately, managing pension liabilities is a core competency of financial services providers. Should a company choose to maintain its pension plan, defined benefit services help employers manage the assets, costs and administration.
However, with market volatility and low interest rates, combined with increasing Pension Benefit Guarantee Corporation (PBGC) premiums, companies face challenges in managing the cost and uncertainty associated with their pension plans. “These concerns take time and attention away from their core business. Increasingly, entities are choosing to remove that risk by transferring the payment obligations to a financially strong insurer,” says Keith McDonagh, Head of MassMutual’s Institutional Solutions businesses.
A pension risk transfer solution helps companies focus on their core business, with the confidence that payments to those individuals continue for the full benefit period. A well-designed pension risk transfer strategy has several important benefits that help companies…
- Reduce risk by transferring the uncertainties associated with plan assets and liabilities
- Eliminate accounting and funding volatility
- Lower expenses by eliminating PBGC premiums and administrative, actuarial and investment management expenses
- Enable a greater focus on your core business, increasing overall value for your organization
The most effective pension risk transfer solution is customized to best fit a company’s business needs. Pension risk transfer solutions include:
- A single-premium annuity contract with an irrevocable commitment to provide the benefits purchased, which can be funded through cash or a transfer of assets-in-kind
- Benefit payments guaranteed to the individuals (or their beneficiaries) through annuity certificates from a highly rated insurer
- High-quality customer-focused administrative services, information and communications
- Availability of general account and separate account solutions
Once you choose to pursue this path, the selection of an insurer for your group annuity is an important decision that requires the consideration of a number of factors to find the right provider. The factors that matter most when looking for a pension annuity provider are financial strength, long-term value, pension experience, and service excellence.
“No one understands long-term obligations better than a company that has over 70 years in managing pension liabilities and defines the horizon in terms of decades,” says McDonagh. “As a leading provider in the pension risk transfer market, MassMutual can help you get there.”
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