United States
Summary
- What should I do if my funded status has improved?
- Can we debrief on funding relief?
- Is something amiss with equity risk?
- What's the deal with these low yields?
- Should I worry about inflation?
1. What should I do if my funded status has improved?
Our take: Protect gains and consider the end-state.
Protect gains: Many plan sponsors have experienced a significant increase in funded status in 2021. Their liability valuations fell, with discount rates up 25-30bps, and assets rose, with equities rallying.
Their first order of business should be to protect those gains, either by reducing interest rate risk, equity risk, or both. Investors can achieve this through changes to their asset allocation and/or hedging policy. Some plan sponsors may have dynamic glidepaths that pave the way for tighter risk controls as funded status improves, and others should at least consider risk reduction to decrease the likelihood of future funding deficits.
To this end, we have seen a noticeable increase in plan sponsors requesting completion mandates, which seek to hedge all or most of the pension interest rate and yield curve risk using physical bonds and/or derivatives within a multi-manager structure.
Consider the end-state: As a plan approaches fully funded or over-funded status, it is a good time to consider end-state objectives. Is the ultimate goal to manage the risk on the sponsor’s balance sheet or to transfer the risk to participants or an insurer?
If the committee expects to continue managing the pension plan internally, it should discuss the target funded status, the complexity of the growth portfolio as it shrinks over time, and revisit risk/reward trade-offs. For example: how much active risk, liquidity risk, and complexity risk should be taken with growth assets that are becoming a smaller part of the pension assets over time?
If the settlor indicates that pension risk transfer is the goal, committees should consider the investment time horizon, target funded status to estimate insurer pricing, and implications for illiquid holdings.
Or perhaps the committee is stuck in a holding pattern, not yet knowing if the company intends to manage or transfer the pension obligations. In each situation there may be an advantage to constructing the pension portfolio to mimic the way an insurer would invest, regardless of whether the end-state investor is an insurer or the plan sponsor.
Figure 1: The average funded status has rebounded strongly1
2. Can we debrief on funding relief?
Our take: Be careful about using it as a reason to re-risk.
The passage of the Infrastructure Investment and Jobs Act (IIJA) in November 2021 continued a decade-long tradition of extending interest rate smoothing measures.
These measures essentially allow liabilities to be discounted at higher discount rates (relative to current market conditions) for the purpose of calculating minimum required contributions, decreasing near-term regulatory cash requirements for plan sponsors.
Although the legislation is more motivated by generating tax revenues (since pension contributions are tax-deductible) than providing pension relief, the outcome remains the same. It is undoubtedly good news for plan sponsors who need the financial flexibility to defer cash contributions, but perhaps also good news for other plan sponsors who are juggling different pension objectives.
Balancing the impact of investment decisions on cash requirements, income statement, and balance sheet liability is a constant challenge and it may be a relief to be able to remove one variable. Consequently, plan sponsors may re-evaluate their asset allocations. We would urge plan sponsors to carefully consider the implications of adjusting risk exposure on all relevant metrics, including balance sheet liability volatility and PBGC variable premiums, and in the context of the current market environment.
Re-risking pension investments at this time is unlikely to have an adverse impact on contribution requirements (given the extension of relief provisions) and is likely to have a beneficial impact on the income statement via a higher Expected Return on Assets (“EROA”) assumption. However, it will likely increase volatility of other marked-to-market metrics. De-risking pension investments may avoid this while also having a minimal impact on near-term contributions.
Figure 2: American Rescue Plan delays and reduces minimum required contributions2
3. Is something amiss with equity risk?
Our take: Consider diversifying growth assets or implementing downside equity protection.
By many metrics, equity valuations are near all-time highs, and the current outlook has caused many financial services providers to reduce future return expectations. As the economy transitions from the “early cycle” rebound to the “mid cycle” (traditionally characterized by a moderation in growth expectations) equity markets have historically become more volatile.
In an environment of increased equity volatility, plan sponsors should revisit their risk tolerance and potential implications for funded status volatility and plan liquidity. Mature pension plans in payout-mode may have a lower tolerance for drawdown risk, especially if a portion of the portfolio is tied up in private or other illiquid assets.
There are several ways to reduce equity risk exposure
A plan could reduce the size of the equity allocation and increase the allocation to either fixed income or diversifiers like private assets, real assets, structured credit, high yield, emerging market debt, and other opportunities. Alternatively, the plan sponsor could increase its allocation to US Treasury instruments for flight-to-quality projection against large equity losses.
For those investors comfortable with derivative positions, an additional strategy could be to purchase downside equity protection via option strategies.
Figure 3: Equity valuations pose three key threats3
4. What's the deal with these low yields?
Our take: Beware of high-quality credit and seek flexibility in lower-rated bonds.
The persistently low yield environment over the past few years has caused fixed income to be a difficult asset class to defend within a total return portfolio. Corporate pension sponsors have particularly struggled since accounting liabilities are best hedged with high quality publicly-issued US corporate bonds, which tend to have lower expected yields than other areas of the fixed income market.
Plan sponsors searching for a higher yield can find it by expanding their liability-hedging toolkit beyond investment grade corporate bonds and into other instruments such as structured credit, private credit, high yield debt (especially “fallen angels”), and emerging market debt. While these particular fixed income sectors may not match regulatory liability benchmarks, we do know that US pension liabilities are difficult to hedge due to credit migration risk, which causes defaults and downgrades to affect assets and liabilities in different ways. The consequence of credit migration risk is that liability-hedging portfolios are likely to lag liability growth.
Note that high-quality corporates are typically incentivized to raise leverage to appease equity holders, while lower-rated corporates are typically incentivized to reduce leverage to chase upgrades to investment grade or avoid a downgrade to high yield (see Catch a rising star: Fallen Angels may hold the key).
Plan sponsors that loosen restrictions on fixed income and target lower quality corporate bonds may be rewarded with higher yields, lower overall spread risk, and therefore lower funded status volatility. This may result in duration mismatches, but we believe investors can be address them with STRIPS or overlays, and the bifurcated approach may lead to better outcomes for plan sponsors.
Figure 4: Credit diversifiers have the potential to lead to better risk/reward trade-offs4
5. Should I worry about inflation?
Our take: US LDI investors may actually benefit from inflation.
Inflation has become a growing concern during the pandemic, fueled by unprecedented monetary and fiscal policy stimulus, a rapid economic recovery, and supply chain issues. While we do agree that it can have significant implications for companies when it comes to operating costs, labor expense, sourcing inventory, and maintaining operating margins, we do not think it is a huge concern for US corporate pension sponsors.
Inflation is no news, or perhaps even good news, for liability-driven investors in the US
Most US corporate pension liabilities have little inflation sensitivity since cost-of-living adjustment (“COLA”) provisions for retirees are rare and most cash balance interest crediting rates tend to be linked to Treasury yields. The impact of salary-based benefit accruals can be material for a plan that is still open to new entrants, but interest rate risk will likely dwarf inflation risk for these plans.
While inflation may not increase the dollar value of liabilities, it may increase the dollar value of assets, which should make it easier to meet those liabilities in the future (all else equal).
Rising interest rates is likely to be less of an issue to pension plans than in the past
One challenge to this view is the possibility of elevated inflation forcing the Federal Reserve (Fed) to raise interest rates, eroding the value of fixed income assets and ending the regime of low yields that investors have lived through the past decade. However, while the Fed has taken a more hawkish stance in recent weeks, we believe this is a manageable risk for investors.
We expect fiscal policy to contract by ~7% of GDP next year, which, combined with improving supply chains and base effects will take the steam out of inflation. Since debt-to-GDP has risen materially over time, we believe the economy’s interest rate sensitivity has also risen, implying that it will take a smaller cumulative rate rise than in the past to cool down growth and inflation. Also note that Fed hiking cycles generally flatten the yield curve giving their moderating effect on future growth, helping to partially insulate long-duration investors from inflation and Fed policy shifts (Figure 5).
While elevated growth and inflation mean rates may move further than currently predicted by the forward market, we do not believe inflation will de-anchor yields from levels they have traded in over the past five years. Therefore, in our view, US pension investors do not need to worry about the asset-liability impact of inflation but can take some tactical views from an asset-only perspective (for more discussion on inflation please see Credit has little to fear from inflation).
Some equity sectors may provide inflation protection
It is often believed that equity investments implicitly provide some inflation-hedging but that is not true of broad market large cap equities, which tend to have historically negative correlations with inflation. However, certain sectors of the equity markets are positively linked to inflation and can provide protection in these types of environments. We believe investing in small cap equities, energy & mining, real estate & REITs, and financials and insurance can provide some desired inflation correlations within a portfolio.
Figure 5: Long-dated yields have historically been unaffected by rising policy rates5
Read our other thoughts for 2022.
