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LDI: What’s on Sponsors’ Minds?
In a move to de-risk their portfolios, more and more plan sponsors are implementing liability-driven investment strategies. In this Masterclass, experts from Goldman Sachs, J.P. Morgan and Prudential focus on the forces driving change and what sponsors should do prepare for those changes.
Gary Knapp, CFA, Managing Director and Head of Liability Driven Strategies, Prudential Fixed Income
Scott McDermott, Managing Director, Pension Solutions, Goldman Sachs Asset Management
Michael Moran, Managing Director, Pension Solutions, Goldman Sachs Asset Management
Owais Rana, Managing Director and Global Head of LDI Solutions, J.P. Morgan Asset Management
Duration:
00:56:28
Transcript:
Masterclass: Liability Driven Investing
Evan Cooper: [0:01] Welcome, I'm Evan Cooper, and in today's Masterclass, we'll be discussing liability driven investing, and moves to de risk defined benefit pension plans.
[0:09] More than two thirds of plan sponsors in a recent CIO magazine survey said they currently implement LDI strategies. To shed light on this growing trend, we've enlisted the help of four expert panelists. They are Gary Knapp, Managing Director and Head of Liability Driven Strategies at Prudential Fixed Income, Scott McDermott, Managing Director and Co head of Pension Solutions at Goldman Sachs Asset Management, Michael Moran, Pension Strategist at Goldman Sachs Asset Management, and Owais Rana, Managing Director, and Global Head of LDI Solutions at JP Morgan Asset Management.
[0:43] Give us a little bit of overview of where de risking, and LDI investing stands right now?
Michael Moran: [0:47] Sure, Evan. As we sit here today, many plans are preparing to de risk their portfolios. When we think about the way the pension environment has evolved over the past decade, we have seen significant regulatory change, the Pension Protection Act of 2006, significant financial reporting change that put the liabilities for these plans right on corporate balance sheets.
[1:07] We've seen a number of different changes from the PBGC, the Pension Benefit Guarantee Corporation, that is guiding more plans to de risk their portfolios. At the same time, more plans continue to freeze and close their plans.
[1:19] For many sponsors, this has become more of a, "How do I run the liability off over time?" We see a number of organizations preparing to de risk, although in the current environment, given the level of interest rates as well as pending mortality rule changes, many of them are not acting today, but preparing to do so over the next couple of years.
Evan: [1:36] Owais, what do you see?
Owais Rana: [1:38] I think everything has been covered. In a nutshell, what we see is that de risking...What I can add to this has taken place in two different, distinct ways. One is, they're de risking off the liabilities of the balance sheet by itself, by offering plan members lump sums where they possibly can. Then, whatever's left over, to then de risk the investment strategy, to match some of their remaining part of the risk that's on the liability side of the balance sheet.
Evan: [2:04] Gary?
Gary Knapp: [2:04] I'd agree. We just had that in this sustained, low interest rate environment. I think plan sponsors have shifted their priorities a little bit out of fixed income hedging strategies and focusing more on growth part of the portfolio, simply because the low rates make them need to.
Evan: [2:22] Scott, what do you see?
Scott McDermott: [2:23] The whole de risking process has evolved over the time that I've been involved. Ten years ago, de risking was all about worrying about protecting myself against a large, adverse move in funded status that would cause me to have to contribute a lot more to the plan.
[2:42] Now, it's going to be a more sophisticated look, which is, what is the endgame that I'm headed for? How do I actually in the long run manage this risk to zero? That's a more sophisticated and more complicated customized answer than just, how do I prevent a big loss?
Evan: [3:03] I guess apropos of where the plans are going, let's talk a little bit first about the new mortality tables that are coming in which have, I don't know if it's going to change things a lot, a little.
[3:15] Gary, let's get your view on that. What are they and what's the impact of it?
Gary: [3:22] Mike is our expert on that subject.
Evan: [3:24] Mike, what's...
Michael: [3:25] I'll make some comments and let others jump in as well. Earlier this year, our friends at the Society of Actuaries issued proposal to change mortality tables and mortality improvement. The good news for all of us is we're all expected to live longer. The bad news for sponsors of pension plans is that the time period over which they will likely have to make benefit payments to participants is probably longer than what's baked into their calculations today.
[3:47] Now, these are still in proposal format. The society has not finalized them yet, and I would say during the comment period there was certainly a lot of pushback from actuarial firms, individual plan sponsors, as well as employer groups about the way the Society came up with their proposal.
[4:04] But to directly answer your question, they have not finalized it yet. We're anticipating that it will probably be finalized by the end of October. That's the Society's stated goal. However, they have reserved the right to postpone or at least slow down the process and not finalized it by October if there's more pushback.
[4:21] What we hear from plan sponsors is that, for some of them, if the mortality proposals were finalized as currently contemplated, it could increase their liabilities by about 5 to 10 percent, and we've certainly heard estimates above and below that range. It really depends on the specific demographics of your participants. Male versus female, young versus older and so forth.
[4:40] When we think about de risking in LDI, so many plans in this country have a glide path or journey plan type strategies that are tied to their funded status. Well, if I was a hundred percent funded and I thought I was at a certain point on my glide path and now the mortality changes, let's say are finalized.
[4:57] Now, maybe for example I'm only 93 percent funded, I'm not up as far as the glide path as I thought I was and therefore maybe I'm not as de risking as much as I thought I was.
Evan: [5:04] Owais, what are you seeing and hearing?
Owais: [5:06] I think that's what we're hearing from our client conversations, that the liability values are expected to go up as a consequence of all of us living longer than what the actuaries expected. What in turn that means is that duration of the liabilities goes longer. What in turn happens as a consequence of that is your liabilities become more sensitive to interest rate movements because now the duration is longer.
[5:32] What we anticipate the market to do is understand, as these pension plans are now not as well funded as just discussed as before, should these pension plans re risk, maintain the level of risk, or just contribute more as a one off hit to the overall funded status?
[5:53] In our opinion, I think the measurement of the de risking part should still be in the terms of risk volatility. That could be measured in lots of different ways. We typically advise on a value at risk measure and where in that risk spectrum does the longevity risk fall, and typically it's much lower down the pecking order. The interest rate and equity risk are primary drivers of that downside risk.
Evan: [6:19] Gary.
Gary: [6:20] Yeah, I think there is a lot of discussion about to re risk or not as a result of the mortality table changes, but I think that's actually a little bit of a fake change. People are already living longer, and if they looked back to what their assumptions were 10 years ago, they're living much longer today and they're paying out more in benefits than they planned at that time. This is really just a feature of the regulation that we have for pension plans.
[6:44] Other people have longevity risk, insurance companies, the PBGC, and they don't follow this methodology. They do continuous improvement in mortality. So, I don't view it as a real signal on risking or de risking because it has nothing to do with markets and other participants don't follow this method.
Evan: [7:03] But the firms, the pension plans will have to make the changes even if it's, in some sense, artificial.
Gary: [7:11] Absolutely. It is a weird thing, and I think if you were to build a journey plan today, you'd want to build in not only today's improvement in the mortality tables, but we'll be doing this every 10 years, and probably your plan is going to go on for many decades, and you need to think about what the further improvement is going to be.
[7:28] What would the impact be if it goes into effect in October? What would happen right away? Would anything happen right away?
Gary: [7:36] Well, the financial reporting would change. As the other fellows said, the funded status would decline because the liability goes up, but from a re risking, de risking on the glide path, that's usually about investment returns. You've had poor equity returns so it's a good time to buy equities, or bonds have really rallied so sell them to buy some stocks.
[7:57] Mortality is a slowly changing thing that isn't correlated to investment markets, and in particular, this method of only changing the table every 10 years is really just an artifact of our regulation.
Evan: [8:10] Owais, you wanted to say something about that?
Owais: [8:12] As I've said, as these pension plans de risk further towards more hedging and lowering down the overall funded status volatility, that will be the point where longevity risk becomes a little more meaningful in the overall risk spectrum.
[8:32] Now, the options will then become whether they want to buy some insurance protection from insurance companies in way of either insurance longevity contracts, or buy outs, or buy ins, annuities that will protect longevity risk, or they take market risk, which might be cheaper but not be as hedge effective from a hedging effective.
[8:55] Those are the kind of routes that we expect them to take, but at the moment, from an investment strategy perspective, I don't see that there'll be any meaningful reason why longevity risk should be driving an investment strategy.
Evan: [9:08] Then we go to the de risking, and Scott mentioned the point it would just be simple to just buy bonds and that's de risking. Is that still going on or is the feeling now because interest rates are so low, this isn't the time to do this, let's postpone it, and wait, and see until interest rates go up and then it'll be better to do that? What's the prevailing feeling at this moment? Gary, let's start with you.
Gary: [9:32] I think the low level of interest rates makes people not want to buy more bonds, and certainly not to sell stocks and buy bonds in this environment, so I think that really does drive the attitude towards de risking right now, but really it's part of a bigger problem for the plan sponsor.
[9:47] There is risk in the plan, and they care about that over the long term because they've made a long term promise on these benefits, and also over the short term because they have to report to shareholders, and rating agencies, and other stakeholders about the current volatility in their plan, so they face a trade off between short term volatility and the long term guarantees that they've made.
Michael: [10:09] It's not just about the level of interest rates. Interest rates have been low for a long time, and I think one of the principal complaints that plan sponsors have about LDI or any de risking strategy is, "Why should I do this now at a level of low interest rates?" Yet the facts are that people are doing it.
[10:27] People are making choices to de risk, and that comes about because...and one big driver is because their funded status is adequate. If you've got enough capital to pay the obligation, why should you take any risk anymore, even if you are buying what you perceive as a risky asset, you also have a...If you're buying what you perceive is a very rich asset, you'll also have a very rich liability on the other side of it. So, funded status is a big driver of people's decisions.
[10:57] Another driver is where does the plan sponsor stand in terms of how big a problem is the pension plan to the plan sponsor. If the plan sponsor feels that the pension plan is taking an undue amount of corporate attention, it's driving up people's time, it's eating up capital, then a sense of, "We can't have this go on anymore," begins to sink in, and then a de risking strategy is often put in place.
Evan: [11:25] Is that feeling prevalent in a lot of corporate America?
Scott: [11:29] The thing about pensions is that everybody is unique, so we could say that there's an LDI trend, but we can't say with any one pension plan whether you should or should not. You have to look behind the scenes. There are certainly some plan sponsors who feel like they've had enough and that regardless of the price of these securities, they're going to pursue a de risking strategy.
Gary: [11:54] If I can just follow onto Scott's comments, we feel like there's a bit of a tug of war with a lot of clients today as to whether this is an investing exercise or a risk management exercise, and clearly for a lot of our clients, and in particular, those that Scott points out, where the pension plan is very material to the organization, as we like to say, materiality kind of trumps everything in life.
[12:14] When the plan is very material to the sponsor, and they are very exposed to the volatility of funded status, they have more of an incentive to use this as a risk management exercise, and those are the plans that we typically see, even in this low interest rate environment, are adding to fixed income.
[12:30] They're extending duration, increasing their hedge ratio, to take down that funded status volatility, and we can point to specific examples of plans that have notably increased their allocations to fixed income over the last year.
[12:41] Ford is a poster child of a plan that has really begun very heavily de risking many years ago. They very publicly announced, "Our ultimate goal is to be 80 percent fixed income," and at the end of last year they're at about 70 percent, so they're heading there.
[12:53] A company like Duke Energy doubled its fixed income allocation last year, so we see specific examples in the market of plans actually implementing this today, but for, again, others, this may be more of an investing exercise, where maybe they can withstand the funded status volatility.
[13:07] The plan isn't that material to the balance sheet, the income status, the cash flow, the sponsor, and they may have a very strong view on interest rates. So, for many of those, even though they have a plan to de risk in the future, to increase allocations to fixed income in the future, they're holding off today because of the level of interest rates.
Evan: [13:24] The funding status, where does it stand now overall? It's pretty good, isn't it, in the 90s, or is it that?
Owais: [13:30] Yeah. The range is between 90 and 92 percent level if you take the average pension plan across the board, but the headwinds from the interest rates going down, which increases liabilities, has offset all the equity gains that we've seen over the last year and a half. Year to date up to August, we've seen equity markets, or US equity markets, go up by 10 percent, but the long term treasury has gone...the rate has gone down to a level where all that good stuff has been washed off.
[14:01] There is a headwind for corporate plans to further de risk as a consequence of further reduction in yields.
Evan: [14:07] One of the issues that's come up, we've heard this in previous Masterclasses, is that, as hard is it to believe, there's a shortage of long duration bonds. Does that pose a problem for companies that want to do this, or is that shortage, am I making too much of that? Anybody want to chime in on that one?
Scott: [14:28] Sure. The truth is that nobody is forced to buy long duration bonds today. There's nobody holding a gun to anybody's head and saying, "You have to do this to meet a regulatory or other obligation."
[14:41] It's just, simply speaking, long duration bonds are, for many defined pension plans, the natural hedging vehicle. They're the most like the liabilities. It's like matching one obligation you're going to pay to a pensioner in many, many years against a bond that's going to mature in many, many years. It's a good asset liability fit.
[15:04] There is a supply issue, meaning that if all plans were to suddenly go the route of Ford, it would be a lot of bonds needed.
[15:17] I think what the truth is, there's not necessarily a shortage, but the planning, the process, you can't say, "Well, I'm going to de risk at this instant," because you don't know what the demand supply relationship will be at this instant. But if you want to say, "I'm going to de risk over time, take advantage of new issues as they come up, take advantage of the secondary markets that become available," that's certainly the right route.
Evan: [15:40] Over time, what's a period that makes sense?
Owais: [15:44] Well, people put in place what's been referred to here earlier as a glide path, where they feel that...and many of these glide paths are keyed off of funded status. Sometimes the glide path is keyed off of interest rates. It says that, "If the funded status improves," for example, "I'm going to take less risk in my pension plan because I no longer need to earn money to create a balance."
[16:09] If you imagine if your funded status is 90 percent now, you have a 10 percent gap to close, but suddenly if the funded status is 100 percent, where's the incentive to take extra return if you already have the adequate capital?
[16:23] People key these glide paths off of funded status and say, "Well, if the funded status reaches 95, I'll add another 10 percent of my portfolio into bonds, but if it's 100, I'll add another 10 percent." Sometimes these things can become very elaborate, but the principle is as funded status improves, generally you're de risking.
[16:45] The thinking is that that'll stretch for many years in the future. It's a long term plan rather than a six month window, and that you're reacting to market conditions, and you're reacting to the funded status of your plan as you're doing this.
Evan: [16:58] Gary?
Gary: [16:59] I think the real effect of that demand over time is to tighten long corporate spreads, and at some point they won't pay you for the default risk anymore, and the asset managers and plan sponsors will have to figure out a new strategy. A way to do that may look more like treasuries.
[17:18] At that time, that may not look so unattractive because with narrow spreads, you also have narrow spreads on the valuation of the liability, so there isn't going to be as much of a gap between those, but if no one wants to own corporate bonds, if they're getting paid less than the risk of their default.
Evan: [17:32] Of course, the heart of this equation of de risking involves selling off the entire portfolio, and going to an insurance company, and getting prepared for that. Where does that stand now? What's happening in that area and how much of that are you seeing?
Gary: [17:48] Well, there were two giant transactions, with General Motors pension plan or with Verizon pension plan, which were both just on the current retirees, a portion of the current retirees, and those companies were in a position, as Scott was describing earlier, where the plan volatility was large enough that it was attracting unwanted attention to the financial statements of those companies, and they needed to reduce their risk, and they went ahead and did that.
[18:16] Retirees are particularly nice from an LDI perspective because they're older people, so they have a shorter lifespan left, so they fit within, say, the 30 year issuance window of corporate bonds, so you can construct a well matched portfolio for those, and a plan can do that itself or it can go ahead and remove it from its balance sheet via an insurance transaction.
Michael: [18:41] I'd be bold enough to say if all corporate pension plans could afford to do a buy out, they probably would, mainly because this problem has been too much to bear, given how the market volatility and accounting changes have actually impacted the company's balance sheet, but I don't think we're there because it is far more expensive to do a transaction with an insurance company to offload the balance sheet than maintaining on the balance sheet today.
[19:10] Having said that, there is still a lot of demand for that product, so to speak, the externalization of liabilities, and as we see more such amount of transactions take place over the next few years, the cost of buyout may increase because there will be more capital that's required by insurance companies to host these liabilities on their balance sheet.
[19:33] At the moment, the equation is what is the economic cost of maintaining this liability on my balance sheet today with [indecipherable [19:38] premiums, and cost of asset managers, and all the other economics that go into maintaining the balance sheet, versus how much does it really cost for me to sell this to an insurance company.
[19:50] At the moment, depending on which plan you speak with, it might be attractive one way or the other, but over time, I think there may be some better economics to maintain the balance sheet for some of the reasons just discussed.
Gary: [20:05] I'll just add a quick comment. When we think about the broader topic of de risking, you have all these different tools in the toolbox. We're talking about LDI. We're talking about buyout annuitization. The term "lump sum" has been brought up.
[20:17] What we see clients doing is not necessarily picking one of those strategies. It's using each tool in the toolbox, and oftentimes, as Gary alluded to, maybe it's annuitizing the retiree because that's the most attractive pieces to annuitize. It's offering lump sums to invested participants, and then maybe it's having a big chunk of LDI for the remaining portfolio.
[20:35] It's not about just choosing one of the strategies. We see clients exploring multiple strategies, and that's probably how it's going to continue to play out over the next few years.
Owais: [20:43] Right. This topic touches on a couple of important trends that have been going on. One is recognizing that there's more than one exit strategy in a pension plan. You can buy a bulk annuity purchase, you can offer a lump sum buyout to participants, or you can build the kind of portfolio that cash flow matched to risk matched that will just run off the liabilities slowly over time underneath your supervision. All of those are reasonable choices, some of which may be more or less attractive depending on market conditions and the timing of events.
[21:21] The implication of that, and the fact of that, is that a lot of these things become much more customized now. As we alluded to earlier, it used to be you just added duration to your portfolio. Now, you really have to study the exact liability structure that you have, and you have to know exactly the risk tolerance of the plan sponsor, and really specify that well, and for the risks you're taking, you have to diversify those well.
[21:50] There's really three levels of customization that goes on. Where does the plan stand in terms of the big risk picture, how many bonds in the portfolio, and how many stocks? It's a simple minded split. Then the customization within the bond portfolio, how do I match those particular bonds to the particularly liabilities of that pension plan? Get it all well lined up so that you can trust that hedge.
[22:13] Then, with the risks that you're taking...I use a simple word, equities . It's a broad umbrella of things diversifying asset classes that try to create the most return for the risks that you're taking within that particular portion of the capital.
Gary: [22:28] I think that's very important. Owais mentioned that people perceive the insurance transactions as being expensive. Part of that is that insurance companies are not Arisa and they have a completely different regulatory environment, one that severely limits their ability to own growth assets, very, very small.
[22:46] It is kind of odd when you think about it that what that means is that a pension plan can be a more efficient investor for long term liabilities than an insurance company, because they can hold more growth assets for those far off in the future cash flows that make up that tale of the liability beyond where you have bonds to invest.
Scott: [23:07] One of the things I'd add is that even if the end game objective is to buy out an insurance company, the strategy of de risking needs to have that in sight such that any customization, or any strategy that is going to be de risking, is going to be a good fit for that insurance like strategy such that at the point in time where pricing seemed attractive, that portfolio can then be...because it's structure very similar to an insurance company would, that could be effectively in kind transferred to an insurer at a respectable rate.
Owais: [23:42] That's another thing I'd say we're working with a lot of clients on today who would say, "We're looking at all this stuff and we don't think we're going to do an annuitization today. We don't think we're going to do lump sums," but that's today. Who knows what's going to happen two years from now?
[23:55] Maybe you have a new chief financial officer comes into the organization, maybe there's a change in strategy so that willingness or ability to have optionality in your portfolio is important for clients because you're going to build a portfolio today that may have one goal, but you really don't know how this is going to play out over the next couple of years, and oftentimes, as we say, sometimes that knock comes on the door and it's, "Oh, we've decided to annuitize 30 percent of our portfolio." Well, is the portfolio ready for that?
[24:20] Clients are very focused on giving themselves optionality because you really don't know how this is going to play out over the next couple of years.
Evan: [24:26] It seems like, when you listen to all the comments, that most companies are striving along this path somehow, juggling all this and trying to figure out what's best. Are there any that are in really great shape and they're just saying, "Everything is OK. We don't have to do pretty much anything right now. We're all right"? Is anybody in that kind of a position or many in that position?
Gary: [24:46] Yeah, I think the pension plans of insurance companies and banks. [laughs] They are asset liability machines and I think they de risked a long time ago.
Michael: [24:55] Yeah, we've got a lot of clients where they have, actually, are in a very good position, and we've created those strategies that are end game and insurance like, so they're sitting pretty, ready to see when prices are attractive to actually just offload those liabilities on the balance sheet, so there are...I wouldn't say majority, but certain pension plans that are in that fortunate state today.
Evan: [25:19] What would be the trigger that would say, "OK, goodbye to the plan"? Is it interest rates going up?
Michael: [25:24] Well, I think it's the pricing where they're going to value it, whether the price of that liability being taken on to an insurance company, the premium that they have to pay is less or greater than the economic cost of holding that on their own balance sheet, which includes longevity risk cost perhaps in the future. You see premiums expenses to administer that pension plan.
Owais: [25:47] I would just say, as with most things in life, there's no one size fits all answer, so we're talking about a lot of plans in this country today that are focused on de risking end game LDI, but there certainly are plans out there that are still open. There are plans that maybe are more, or companies that are more, paternalistic in nature. Maybe it's a private company that's not beholden to quarterly earnings.
[26:06] As we discussed earlier, for some plans, materiality trumps everything. The plan just may not be that material, so they may be perfectly happy saying, "Our plan is still open, incurring new benefits. We can withstand that funded status volatility. We're happy with a more growth oriented portfolio."
[26:20] There certainly are examples out there, but I would say that they are in the minority. Most plans are more focused on de risking, but I wouldn't paint them all with this broad brush as, "Everyone's de risking," because certainly, for some plans, it's going to be a steady state type portfolio.
Michael: [26:34] Some of the pension plan design has changed by plan sponsors. We hear cash balance plans come up quite a lot now because the sponsor doesn't want to take the entire investment and actuarial risk on their own self, so what they've done is create some kind of a hybrid offering that creates a good fit or mix of risk being shared by the member as well as the sponsor.
[26:58] We've been working with some of the clients where we're trying to create the best LDI strategy, so to speak, for cash bond plans, which is completely kettle of fish.
Owais: [27:08] Yes. That is part of the trend too, that there are many plans who converted from a defined benefit obligation to a cash balance, or a years of service kind of formula to a cash balance formula in a defined benefit plan, so that conversion may have happened a decade ago, and now that cash balance bond as part of the liability is becoming increasingly important, and how do you manage that.
[27:36] Then there's the rare plan sponsors who have an inflation index obligation, and that's a little bit different kettle of fish. Again, this whole idea of customization, you need to look beyond the surface. You can't just say, "Oh, you have a pension plan. I know what you should do." It has to be a lot of questions and probing has to happen to figure out exactly what is the nature of this liability and the nature of the plan sponsor before you can really confidently make a recommendation of what the strategy should be.
Evan: [28:06] What kind of plans would LDI not be the best thing to do? Who isn't this good for?
Owais: [28:12] Well, in an inflation index plan, you don't want to go buy long maturity bonds because you're fixing the assets at that future date, or at least long maturity bonds that have a nominal coupon to standard traditional bond, because inflation could go up, and then your liability could grow, and then the asset you hold isn't growing, so that creates a risk.
[28:32] They need a different kind of thinking where you have to construct a portfolio that's inflation sensitive in order to do that, and that's possible but less of an easy answer than the traditional, un indexed benefit.
Scott: [28:52] I think Mike said it best earlier, that LDI now is a toolkit with a whole bunch of different tools in it, and you can apply those probably pretty universally, but the answers to each plan are going to be different. They're going to use those tools differently.
Evan: [29:09] What about interest rates now? Everybody is waiting for them to go up. So far, they're not going up. There's always the chance that they will soon, but they seem to be where they are now, and who knows, but if they do go up, what would happen to the de risking movement, so to speak?
Owais: [29:27] Well, if interest rates go up by themselves, and that's all that happens...in general, there are very few plans that are fully liability hedged. There seems to be some interest rate exposure, and rising interest rates, everything else constant, improves funded status for those plans, and it'll improve funded status for the bulk of pension plans in North America.
[29:53] My earlier argument about funded status being the trigger points in these glide paths. That would tend to increase the demand for liability hedged investments, meaning typically the long duration fixed income.
Michael: [30:01] I think you're absolutely right. A sharp rise in interest rates might not be good for their growth assets either, and what they're really focused on is funded status, which is a combination of the growth portfolio, the hedging portfolio, and the liability value, so it depends how those rates go up, but I think in general, yes, they're very exposed to a rise in rates. They would benefit from that, and that would push them along their glide path or journey plan to further de risk at that point.
Scott: [30:31] Well, the comment that I'll make is that which part of the curve do the rates really go up by, and how much? If the rates which we expect as a consequence of change in the Fed's positioning now in QE easing and the tapering of the intervention. We'd expect the shorter end of the curve to be going up quickly, more in a shorter period of time.
[30:54] On the long end of the curve, which is where the bulk of these liabilities are sat today, how much will that go up by? Because there's a lot of demand pressure at that kind of the curve, and given the mundane growth that we see and geopolitical issues that we see, will the long end really go up by that much?
[31:15] Maybe if a plan is an owner of a shorter duration bond, if rates go up by approximately one, one and a half percent on the shorter end in a five year duration, say roughly, that would equate to about a 50 basis point increase on the longer end of the curve in terms of the equilibrium.
[31:33] We'll have to see how much better off will that pension plan be on a shorter duration bonds and not the longer end of the curve.
Michael: [31:41] I get the benefit of making the last comment on this topic. We've covered a lot of it already, but I'd say that the key here is let's say rates go up on the long end of the curve, and to the points that have been made, that would be positive to funded status.
[31:54] The reality, as many of us have enunciated, is many plans in this country have some sort of glide path or journey plan tied to funded status, so to the extent rates rise, funded levels go up. We all go up our own glide paths.
[32:08] That means all these plans now are going to be jumping into the market, looking to buy the same bonds at the same time, and as we discussed earlier, there's a scarcity value there, so I think to that point, are we potentially going to see some spread compression at the long end?
[32:21] It's something we watch. It's something that many of our clients are focused on because, again, if we have a glide path, we know everyone else does too, so when rates start to move and our funded levels start to move, so will everyone else's, and that's where this whole supply/demand issues really starts to come into fruition.
Evan: [32:36] Let's look at equities just for a second because in 2013, the boom in the equity market seemingly caught everybody by surprise. Funding levels went up and they were like, "Woo, this is great." They had the benefit of the equity markets.
[32:49] What happens if we have an equity market correction more than just a couple of points, something that's somewhat significant, maybe not to the degree of 2008, but something large, and people get...what reaction would that have? What would there be aside from some of the fear and the globe of a market correction? How would that affect pensions?
Scott: [33:09] Well, as Gary was saying, it depends on how equities and rates go and move together. In a situation where rates rise and equities fall, the two might offset each other, so funded status could be similar. Then there would be no material increase in demand, or perhaps very little, at that point.
[33:30] If equities fell by themselves, then everybody goes down their glide paths and they get disappointed in terms of where the future holds, so they're either re risking, which might possibly mean selling bonds, or they're having to extend their horizon for when they think they're going to be fully funded again.
Evan: [33:50] Gary?
Gary: [33:50] Yeah, I think Mike mentioned all the pension plans if rates go up may be rushing in to buy some more bonds. They won't be the only ones either, so bonds are a global market, and rates in safe countries, the rates in the US look pretty good. They're higher than in a lot of other well developed, rich nations, and I think that a rate rise in the United States would attract a lot of international capital as well, and there'd be a much bigger food fight for the bonds at the long end of the curve.
Evan: [34:19] Anything to comment on that?
Owais: [34:21] No. It's quite obvious that equity markets fall, funded status falls, and there may be either re risking or companies will say that, "We took our chances and contribute because this is a cost to our decision making," but I'm assuming, I'm going to give them the benefit of doubt, that when they decided a de risking or glide path, they assumed that they're going to be taking some risk, and they're prepared for that risk.
[34:47] Nothing changes from that perspective if I give them the benefit of doubt of that risk management and understanding the tolerance levels.
Michael: [34:54] I think it comes back to something we've all discussed, which is de risking is not just about more fixed income. It's how do you better diversify your return generating portfolio. For many clients, equity beta still dominates the risk of the return generating portfolio. So, a lot of clients who come to us today say, "I can't stomach buying long bonds in today's rate environment, but I know I have too much equity risk."
[35:12] For many of them, that interim step is, "How do I diversify my return generating portfolio away from equities?" and that may not even be getting out of equities. It could be reducing home country bias. It could be diversifying across different market capitalizations. It could be low volume equity strategies.
[35:29] That's part of the de risking toolbox as well as how to think about de risking away from equity beta as part of the return generating portfolio.
Evan: [35:36] Does this imply, you mentioned this earlier, a greater internationalization of the investments? We tend to be US centric here, even institutionally. Does this mean that they're getting more international in their investing tastes?
Scott: [35:52] It certainly does, yeah. It certainly implies that as one part of just being more diversified in their investments. Instead of relying solely on equities, you can also look at other risk factors that we think have positive excess return that are attractive, credit, for example, real assets, a number of areas where you could diversify alternative strategies that pension plans are using.
Gary: [36:23] I'm sorry. Go ahead.
Scott: [36:24] I was going to come back. In terms of creative investment strategies, there's all sorts of strategies that you can think of or use, in fact, some people are using them, to address the issue of supply and what happens when hypothetically, everyone would want to buy bonds at the same time, and that is you can always warehouse long maturity securities of the kind of issuers that you find attractive in a portfolio, but hedge down the duration risk.
[36:52] You don't have to take the industry risk. You can take the credit risk. This is a one credit strategy, and then when you hit your glide path point that you're going to add more liability hedging, you simply remove the duration hedge and all of a sudden you have the bond portfolio that you need, so that is one strategy that some clients are using to address that particular problem.
Evan: [37:16] You want to talk about the internationalization part?
Gary: [37:18] Yeah. On the internationalization side, I completely agree on the growth portfolio, but we don't see a lot of internationalization in the hedging portfolio, which is mostly about US corporate bonds, and I think part of what holds that back is what's available in the global corporate bond market is mostly the US.
[37:35] We have the most developed corporate bond market there, and I think that people see limited diversification there so far, and that's a little disappointing that that hasn't moved along farther, but if you do go to Europe, say, or some place like that, the long bonds tend to be banks and utilities, concentrated in those sectors anyway, and we have plenty of those in the US too.
Evan: [37:57] Do you have any comment on that?
Owais: [37:58] I think I'll echo some of the stuff that's already been said. Within the growth portfolio, what we've seen is expansion on international exposure through not just equity markets, but even in the fixed income markets, where emerging market bonds have, either local currency or high currency, have become more popular within that strategy, even high yield to some extent and some private debt.
[38:19] There's a lot of different sub sectors of these major asset classes that are seeing a lot more international exposure as a consequence of maybe there's not enough opportunity in the US anymore because it's a little more efficient to capture some of that inefficient market in various different, broad sectors of that growth portfolio. We've been missing that.
Evan: [38:38] One of the issues in going international goes counter to what we were talking about before, that this is more complicated. It adds another dimension of either complexity or responsibility on the part of the plan sponsor to know about all this stuff, and even if they choose to hire experts to help them, it's still managing them is a job.
[39:00] The idea of the increasing complexity, is that another reason for them to say, "You know what? In order for us to do this well, it requires so much work on our part. We still don't want to do this anymore." Is that a fair statement, or they just say, "It's worth taking on the extra work to do this, to manage it ourselves"?
Gary: [39:18] I actually think that that's really not a problem so much anymore. It's more how they analyze the risk return trade offs, because I think, certainly, most plan sponsors have gotten the international and diversification message in equities over the last 10 years, and have much broadened their equity portfolios substantially, both internationally and into alternatives.
Owais: [39:38] I would say that I think the biggest hurdle is, I think to Gary's point, is the strategy. If they could get the strategy right, implementation of the specifics within that strategy are not that difficult because there are plenty of execution agents through asset managers and they're specialist managers that can apply their skill sets to the various different sleeves.
[40:02] But the biggest point that I think I want to reiterate is getting the strategy right. It's a blend between the growth or hedge, if that's how they're broken up, or the overall risk spectrum versus the liabilities in that de risking framework.
Scott: [40:16] That said, there is a trend now that wasn't present 10 years ago of for certain plans, or certain organizations, just outsourcing the entirety of the investment management function to a third party, a sort of outsourced CIO environment, is an appropriate response, and there are many pension plans that have chosen to go down that route, partly because of the increased complexity.
[40:47] It's not just in what you're investing in. It's the whole idea of customization that I mentioned earlier. It all has to be customized and you really have to dive down to that level of detail. "Hey, why don't I get a specialist to do that for you?" It's also because of the evolution of the importance of the pension plans to the plan sponsor.
[41:05] Once you close a pension plan, you're kind of making a statement that it's no longer a central part of my benefit policy, and it's no longer a core part of my business or a business approach. Why not then outsource that to a professional as you do in other areas of your business?
[41:23] That is a trend that has picked up, and I think a very useful one in those circumstances.
Evan: [41:29] There have been studies that show that once companies give up their defined benefit plans and switch, their stock price goes up over time. Does the stock market feel the service you've done the research, adequately reflect the risks that are in the pension plan? We talk about de risking. It seems like it's chock full of risk. Does the market get that or does it price it accurately, you think?
Owais: [41:58] I don't think the equity analysts are spending enough time yet on the pension plan exposure that feeds into the overall corporate balance sheet. I think they have started to look at it, but it's a function of how much of reporting is forcing them to look at this, which still remains to be seen.
[42:19] Certain companies...so I think to Scott's point earlier, which is if the pension plan is a big burden to the corporate balance sheet, I think the equity analysts will ask a lot of questions. They'll probe in terms of what the strategy is for the pension plan down to the level of how well funded they are, what the investment strategy is.
[42:38] But for an average plan sitting on a decently sized balance sheet, I don't think there's enough focus on what the plan strategy is as much as I think there should be, given that, economically speaking, it's a tax on shareholders because that company needs to be making widgets, and spend the most amount of risk and money in that operation as opposed to making calls on capital markets through their pension plan.
Michael: [43:04] I would agree with that. I think, again, it's sort of "You can't paint everybody with a broad brush." When we say, "Do analysts, do investors, understand this?" I think in those industries where the pension is very material, so think about an industry like autos, those analysts, those investors, they get it. They've lived through this through very many cycles. They've spent a lot of time on it. They understand it very well.
[43:24] For others, it's just not something they spend a lot of time on, and keep in mind, especially from a financial reporting perspective, they only get information on these plans essentially once a year, so it's not really something during throughout the year, they're monitoring that much. They're not getting updates from companies.
[43:39] It's really not their core competency so I think there's a pretty wide range of understanding of pension issues and how it affects, again, balance sheets, income statements, and cash flows.
[43:48] Keep in mind as well, since many plans have been closed and frozen for many years, you have a number of analysts and investors out there who are, let's say, in their early 30s. They don't even know what a pension plan is. They've never been covered by one, so it's kind of a foreign concept to them. It's becoming more of a dinosaur.
[44:05] I think for some of them, they have gotten farther up the curve, and again, a lot of the accounting and regulatory changes over the past decade have made them focus on it more because we've introduced more of a mark to market system, but it isn't something they do every day.
[44:18] It's something that maybe they looked at years ago during the last downturn, but now the last couple of years they haven't focused on it as much, so I think there's a pretty wide variety of understanding of pension issues.
Gary: [44:29] Yeah, I think Mike's point is a good one. I think the studies that you're referring to are the ones that show that companies with large pension liabilities underperform in down markets, and I think that that's exactly the consequence of what Mike said, that investors aren't thinking about the pension plan most of the time, but when it's a down market, they get worried about it, and that gets reflected in prices and returns.
Evan: [44:52] Of course, the under funding, now that most plans are, as I said, in the 90s, it seems like, "Oh, that's OK. They're very well funded so let's forget about it." It doesn't really come up much until the funding go down again, and people look at the level and say, "Gee, these companies have this big obligation."
Michael: [45:10] They don't care until they care.
Evan: [45:12] Right. Of course, the bonanza of when...the study I was referring to, is how there's...I think they've monitored stock prices for a year after a company gives up their defined benefit plan, usually the stock price goes up, but again, it could be a function of there was a time when equity prices were rising generally anyway, but it seems like that the market seems to react very favorably to getting rid of this liability.
[45:37] We talked about the risk, de risking. What is the risk to the shareholders in having the pension plan? What's the worst that can happen that's sitting there that people don't realize?
Michael: [45:54] I would say that one of the risks they may not realize is that even a fully funded, closed and frozen plan has risks, and it comes back to asset liability mismatch. We can look back in time at previous examples of plans that were over funded, closed and frozen.
[46:11] As an investor, as a creditor, as credit rating agency, I may look at that plan and say, "There's nothing to worry about. They're 110 percent funded. They're not accruing any new benefits. What's there to worry about?"
[46:22] Well, because of the asset liability mismatch, you get an equity market correction, you get long term interest rates falling, and suddenly 110 funding becomes 80 percent funding, and suddenly now, to my point earlier of, "They don't care until they care," everyone really cares.
[46:37] I think sometimes what is missed is there are risks even in a plan that looks like it's doing very well.
Owais: [46:45] I'll take it further from that. That means that that hole now needs to be filled, which has to be potentially from the company's free cash flow which otherwise could've been invested in the company itself for growth purposes.
Evan: [46:59] You want them to focus on widgets?
Owais: [47:01] Yes. Or it would go into the pension plan, which means that you're taking shareholder value away from why they had invested in that company.
Gary: [47:14] Yeah, the cash that goes into the plan is no longer available for dividends, share buybacks, or investing in new businesses, operating businesses that could earn a high ROE, so eventually that could happen, I think. Your study says that they think about it a little bit, but it seems like it's kind of far off in the future.
Evan: [47:33] How far is the gap from the time that the company knows that it's under funded, like when the funding slips, until they report it? When do they have to tell the public that, "We're under funded. We went from 90 to 75," for example? How long do they know when nobody else knows?
Michael: [47:52] Well, that really comes back to, really, you only report these numbers once a year in your annual report with the SEC. Now certainly during periods of market stress, and we saw this during the 2008 time period, companies would periodically update through the year, especially when you think about the fall of 2008, when equity markets were correcting, and provide an update because, again, the investment community was really demanding it and where does the plan stand.
[48:16] But the reality is you really only publish these numbers once a year from a financial reporting perspective.
Gary: [48:21] I think it's true in supplemental information and quarterly earnings announcements, anybody with a substantial plan which has an effect on earnings is going to be talking about it.
Evan: [48:32] Scott, did you have anything to say on that?
Scott: [48:34] Yeah. A minimum three month lag for most material plans, and you won't hear about it for a year.
Evan: [48:41] There may be some scrambling during that period that we don't hear about to get the funding up there.
[48:51] Are there any other issues you're finding out in the market, something that you feel is interesting that plan sponsors are their consultants would find helpful, a story from one of the plans that you've helped of something that they've tackled recently that would be helpful to other plans out there?
[49:11] Anything that's come up and the way you've helped them do something in an innovative kind of a way or a new tackle on the problems that they're having that others might find interesting?
Gary: [49:23] Yeah. I think one trend I see is one Scott's mentioned already, which is to go out and buy long corporate bonds today because there may be a shortage, or spreads may be tighter in the future. But they have a strong view on interest rates, so they have the manager shorten duration by using derivatives, for example, to reduce the overall duration of the portfolio.
[49:41] We certainly see people continuing to buy long bonds and then take off some of the duration.
Evan: [49:46] Is there anything you've seen?
Owais: [49:48] Yes. In addition to that, I'd say that where plans are very well funded who do not have an interest rate view in those cases, we have designed a more customized strategy, which will include a little more curve matching and credit matching across the curve as opposed to just buying a long duration bond mandate through the market index universe, so we've done something more custom for that client to match the overall risk profile of a pension plan.
Evan: [50:18] We're reaching the top of the hour of this Masterclass, so let's go around and get some takeaways. What should plan sponsors be thinking about their advisors, consultants? What should they be thinking about when you think of de risking and liability driven investing?
Michael, let's start with you.
Michael: [50:35] I would just say just understanding that it's a process, it takes time. Again, I'd say we work with a lot of clients who say, "We're not there today because our funded levels are too low or we have a view that interest rates are going to go higher," but it takes time to implement this. It takes time to get the governance right.
[50:53] When you move from an asset only world to suddenly it's an asset liability world, the way you measure success, the way you define success, changes. So, it's getting everyone on the investment committee onboard ahead of time so that way, if interest rates spike, and equities hang in there, and suddenly we go from 80 percent funded to 95 percent funded, and we're going to move up our glide path and implement LDI, that's a shift in strategy that's going to have a number of ramifications.
[51:15] It's kind of laying that groundwork today and understanding that when you move to an LDI type framework and asset liability framework, there is a number of issues you've got to make sure everyone is on board with from a committee perspective.
[51:26] So, I think even for those that aren't moving today, we see a number of plans appropriately asking the right questions today and putting the process in place today, so that over the next couple of years, they'll be able to implement it once interest rates start to move and funded levels start to rise.
Michael: [51:40] Nice.
[51:42] [laughter and crosstalk]
Michael: [51:50] The only other thing I'd add to that is, to plan sponsors and their advisers is that as they're defining this framework, have an end game in sight, whether that is either to offload it to insurance company or maintenance of the balance sheet, have something in mind. At what point would you like to completely or a majority of the risk between asset liabilities mitigated, or minimized?
[52:16] Then as you do that, because now your equity or growth or risky asset allocation is going to reduce and hedging strategy is going to increase, as the hedging strategy evolves over time, what should that look like? Let's make sure that the hedging strategy's the best fit as much as possible at different de risking points in time.
[52:40] In other words, customization at some point will kick in because you're trying to hone in as much risk on the interest rate side as possible through credit spreads, interest rates, and a curve mismatch.
Evan: [52:52] But what do you think is the biggest stumbling block, then, picking up on what you said about having a strategy? What's the reluctance to have one of those? Is it just that it's difficult to think it through? What keeps them from having it?
Michael: [53:02] I think we've discussed what that is. It's the headwinds of where the rates are today. I think it's that asset only mindset. Also perhaps even on the corporate balance sheet, if I buy bonds today my expected income on my balance sheet is going to go down, which may hit the bottom line in terms of earning per share. Those two angles today are probably, that's the reluctance in terms of the overall de risking exercise today.
Evan: [53:31] Gary.
Gary: [53:31] Yeah, and I think that's an important point. I think plans do need a strategy in which for an environment in which long term rates stay low for quite a long time, and I don't think a lot of people have thought out clearly what that means.
[53:45] Because it doesn't mean that the risk goes away in your growth assets, so they may be holding onto volatility in the plan for a much longer time than they intended. They should think about whether they really want to do that. I think that can be a motivation to at least do a partial de risking, even in a low rate environment.
Evan: [54:04] Scott.
Scott: [54:06] From my perspective, the recognition that this is a really customized, unique, unique to the individual plan process, and that there is a lot of complexity to that customization. Be willing to embrace that complexity and put a plan together.
[54:25] Figure out where you are in the risk spectrum. Figure out how to best match the liability hedging you're doing to the liabilities of your particular plan. Figure out how to diversify and get the most return per unit of risk you're taking elsewhere. Very tough investment problems, each of them individually.
[54:47] I think the interesting thing about today's discussion that I noted is that none of us have talked about the use of leverage or overlays in a program. As we think out the endgame, the endgame for these pension plans is a portfolio of bonds, and it's not a portfolio of derivatives.
[55:13] When people were trying to simply add duration to the portfolio, perhaps an overlay was the right initial step. But as these plans grow and mature and you really start to approach your endgame, you're not using derivatives anymore. You're investing in the bond markets and physical securities. That's another interesting twist to the market as we've evolved in the LDI process.
Evan: [55:36] Terrific. It was a complex discussion and I thank you all for your insights. Michael, Owais, Gary, and Scott, thank you so much, and thank you all for joining us. This is Evan Cooper for Asset.tv.
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