In an African desert millions of years ago, a mysterious black structure appears before a band of ape-men. Exposure to this monolith pushes the hominids to make a huge technological discovery: the ability to use weapons to kill prey and defeat enemies.
Institutional investors were never quite so primitive as the pre-evolutionary beings imagined in Stanley Kubrick’s 2001: A Space Odyssey. Nor has investing advanced to the extent of the humans in the future depicted in the 1968 film, their lunar research base and artificially intelligent supercomputers a giant leap from the great apes’ simple bone clubs.
The 21st century has seen corporate pensions undergo an evolution of their own: from growth-oriented 60/40 portfolios of stocks and bonds to customized, low-risk, liability-driven investments (LDI). Rather than being prompted by some strange pillar sent by a benevolent alien race intent on the advancement of less-evolved species, plan sponsors have been driven by more ordinary—but no less powerful—forces: market movements, regulation, politics, and, above all, an obligation to their beneficiaries.
Moon colonization might be a long way off, but a majority of corporate pensions are at least on some form of de-risking glidepath. (Also, frighteningly, artificial intelligence development is rapidly closing in on Space Odyssey’s murderous HAL.)
And the LDI evolution is far from over. Managers and consultants have set their sights beyond the corporate defined benefit (DB) space and are targeting the next adopters of outcome-oriented investing: defined contribution (DC) plans—and maybe even public pensions. Meanwhile, though corporate DB plans have started on the de-risking path, widespread funding deficits and stagnant interest rates mean they too will continue to evolve over the next decade.
What does the future hold for LDI?
“First you have to ask how many defined benefit pensions will be around in the next few decades,” says Mark Thompson, CIO at BP America. Corporate pensions haven’t just changed their investing style over the last several years. They’ve overhauled their plan offerings, shifting from DB to DC—and at some plan sponsors, from final average pay to cash balance plans (more on that later).
“In the US, the majority of plans are closed or frozen,” says Jodan Ledford, head of US solutions at Legal & General Investment Management America (LGIMA). “You’re not incentivized to get overfunded—any leftover dollars are subject to a giant excise tax, and the IRS [Internal Revenue Service] will get most of it. That’s where LDI comes in.”
With an economic incentive to de-risk, “a meaningful swath of the US corporate universe will either be de-risked or certainly have a much lower risk profile 10 years from now than today,” predicts David Eichhorn, managing director at St. Louis-based LDI shop NISA.
The difference between the LDI of today and the LDI of tomorrow? Customization. “The next step is not just aligning assets with similar sensitivities to the liabilities, but investing in assets that will actually track the liabilities,” says Ledford. “Not only managing to the duration of the plan, but really understanding the liabilities’ cash flows and aligning to how those liabilities fluctuate.”
“The first step was to buy blunt long duration assets,” explains Owais Rana, head of investment solutions at Conning. “Now that I’ve got duration, I need to start looking at whether I have enough credit spread and also which part of the yield curve I need to allocate these additional assets to. Because my liability cash flows do not look like a standard market long bond index.”
Another emerging trend is what NISA calls “hibernation”: An alternative to termination via pension-risk transfer (PRT), it’s the fully de-risked “end state” of a de-risking glidepath. “So far relatively few plans have been able to get that far down the de-risking continuum,” Eichhorn says, “but we expect to see more as either contributions or hopefully markets push plans into that fully funded state or beyond.”
Pension assets will still continue to trickle into insurers’ pockets through annuity buyouts—running a pension, after all, is not the primary business of most corporations. And in the US, ever-mounting Pension Benefit Guaranty Corporation premiums, which charge plan sponsors by the head, present a compelling economic case for reducing the number of participants in the plan.
But don’t expect PRT deals to become the norm. “The volume of liabilities that insurers are willing to take is lower than the amount corporate plan sponsors owe,” says Ledford. “Simple supply and demand means the price of a pension-risk transfer is going to get very expensive. Pensions and managers will have to change their lens to think about how to manage these liabilities to termination themselves, because there’s not going to be enough capacity on the insurance side.”
At Conning, Rana envisions pricy risk transfers resulting in more inventive solutions—do-it-yourself buyouts, for example. “You’re going to see more interesting ways of managing the risks that can’t be hedged in capital markets, like longevity risk,” he says. “Already in the UK we’ve seen longevity-risk transfer solutions packaged in a variety of ways including derivative instruments.”
In general, the UK is a good place to look when predicting the future of LDI. “You want to know what’s next in de-risking? Check out what they’re doing over there,” adds Ledford.
Take manufacturing giant ICI, for example. The UK chemical firm has completed 11 buy-ins since 2013, securing £2.5 billion ($3.06 billion) this year alone. Other UK pensions—namely the BT Pension Scheme and the Merchant Navy Officers Pension Fund—have established their own insurance subsidiaries to which they could transfer longevity risk. In BT’s case, the pension insured £16 billion of liabilities against longevity changes with its wholly owned company before reinsuring through a swap arrangement with Prudential. At the time, Paul Spencer, chairman of the fund’s trustees, called the transaction a “ground-breaking deal” that “significantly reduces risk and provides enhanced security for members.”
The UK has also seen plan sponsors adopt pension increase exchanges—wherein members are offered a raise in their annual payments in exchange for sacrificing inflation protection—and price locks, which secure a buyout’s price at the outset of the transaction. Automotive company TRW’s pension made use of both in its November 2014 de-risking exercise.
In Europe more broadly, funding rules have been the main driver of innovation in de-risking. In Sweden, for example, pensions are required to maintain a funding ratio of at least 104%—making liability-matching a way of life rather than a catch-up tool as it is often used in the US and UK. “In central Europe we are more religious about liability-matching,” says Peter Hansson, CEO of Swedish bankers’ pension SPK. This investing creed has resulted in some investors stocking up on long-dated bonds—a trend that could prove problematic in the years ahead, Hansson warns.
“You want to know what’s next in de-risking? Check out what they’re doing in the UK.”“Falling interest rates have helped us in the last 30 years,” the CEO continues. “In the next few years interest rates will be going up, so liabilities will decrease. Those who are buying bonds today are in danger of getting a bad [return].” For this reason, SPK exited long-only bonds a few years ago, and now uses dynamic funds that can go net short and take no duration risk. “We are just waiting for interest rates to go up,” he adds.
The question of interest rates is a prominent one—perhaps the biggest challenge de-riskers face in the corporate pension space. “For an extended period of time, rates have either been constant or going down,” says Jess Yawitz, NISA’s CEO. “Some of our client prospects that are considering LDI say, ‘How can we buy bonds at these high prices and low yields?’” As investors have accepted the “new normal,” however, Yawitz says he and his team have been pleasantly surprised by the level of LDI activity. “At least our rates aren’t negative,” he jokes. “It would be much more difficult to talk anyone into an LDI strategy in Germany or Japan or Switzerland.”
Funding levels pose another hurdle. “The fact that funded status has not improved—or if anything has gone down recently—on balance just slows movement down the de-risking glidepath,” says NISA’s Eichhorn.
If funded status is an obstacle for corporate pensions, don’t expect public pensions to go full-tilt LDI anytime soon. “Theoretically, LDI could work in the public space,” says LGIMA’s Ledford. “But there are a lot of barriers to entry—funding deficits first and foremost.” On the surface, most American public plans are underfunded—the worst as low as 19% funded, thanks to poorly performing investments and insufficient contributions. Dig deeper, however, and these deficits may be even larger than they appear.
In the US, public pension liabilities are discounted using a fund’s own expected rate of return—many of which are already unrealistically high. A CIO poll of allocators conducted this summer placed official long-term rates of return for public plans at about 7.5%. Their best guess at actual returns, however, was 6.78%.
“For a long time, investors could count on a 7.5% to 8% return,” says Dave Wilson, head of the institutional solutions group at Nuveen. “But the last 10 to 20 years, they haven’t met those returns—and there’s not much evidence that they will. They would need to take three times the risk compared to 20 years ago to have a chance at those kind of returns today.”
De-risking out of growth assets would further shave down expected returns—and, ultimately, the funded status. “Public pensions are incentivized to keep more risk,” Ledford argues. “If you were to apply LDI thinking to public plans, the deficits would be in the trillions. No one wants to go to that lens.”
“Theoretically, LDI could work in the public space. But there are a lot of barriers to entry—funding deficits first and foremost.”While Eichhorn and Yawitz point out that there have been “baby steps” toward mark-to-market accounting for public plan liabilities—valuing pension obligations based on objective market prices as opposed to return assumptions—they agree that it’s going to take longer than 10 years for public pensions to get to a place where de-risking will be palatable.
And don’t even think about a pension-risk transfer. “Public funds are so out of the money that it’s not even an option right now,” says Wilson. “That may be the ultimate moonshot: a public pension buyout.”
Despite such headwinds, LDI thinking may have already trickled into public funds. “Already we’re seeing a shift in how investors think about risk management in the public sector,” Wilson says. “The leaders in the space are developing risk-aware, liability-aware approaches.”
The $7 billion Contra Costa County Employees’ Retirement Association, for example, has developed what Wilson calls a “functional asset allocation,” with investments designed to meet the fund’s growth and liquidity needs while still hedging against volatility. Others, like the Hawaii Employees’ Retirement System, are applying a risk lens to their overall portfolios through factor-based approaches, if not quite de-risking. Baby steps.
Where an LDI approach is more likely to flourish—and in some cases, has already taken hold—is the defined contribution market. “In the DC space, you can think of a liability as the pension you owe yourself in retirement,” says Eichhorn. “In that sense, the cash flow profile, the life expectancy—all those things are very similar.” At NISA, Eichhorn and his colleagues have been applying LDI concepts to developing DC strategies for a few years now. “It’s really just code for income stability in retirement,” he adds.
In part, de-risking DC plans will mean institutionalization. “One of the things I’m hoping for in DC is for target-date funds to become more sophisticated, more risk aware,” Wilson says.
UK consultancy Redington has already taken a step towards this with a customized DC plan for its own employees, which updates participants’ default funds on an annual basis. Buying a house or just got a pay raise? Your fund will be adjusted accordingly.
De-risking DC also means annuitization, according to Ledford. “LDI in DC will effectively mean transforming a pile of money into an annuity,” he explains. “Instead of a lump sum, here’s a monthly payout stream with some flexibility to take more money out in case something happens.” Even taking out 10% of the grand total to buy a deferred annuity will help individuals match their liabilities by ensuring they don’t outlive their pot of money, he adds.
While asset managers are enthusiastic about taking LDI to DC plans, BP’s Mark Thompson is less optimistic.
“You have to be able to calculate what the DC liability is,” he explains. “If you could calculate a PBO [pension benefit obligation] equivalent for DC plans across corporate America, the aggregate funded status would likely look fairly poor in contrast to DB plans.” Looking at DC from a liability perspective, he says, just shows how challenging the situation is. “People are looking into lifetime income, but I don’t think anyone’s really looking deep into individual liabilities and how to create a system to mitigate that,” he adds.
And then there’s BP’s cash balance plan, a sort of hybrid between DB and DC in which a set benefit is determined based on the account balance—and for which it is difficult to create an effective LDI strategy. ‟I haven’t found any managers with a good cash-balance hedging solution if long rates eventually rise,” he says. ‟Trust me, I’ve looked everywhere.”
Where’s a benevolent alien race when you need one?