The End Game is Near

aiCIO: We should begin with the market environment, which has changed significantly, not just in a year, but over the last five or six months.

Fogarty: The global markets were unprepared for Chairman Bernanke’s “taper talk” in May, which laid out the possibility of a reduction in stimulus, possibly some time in the fall of 2013. The result was a significant sell-off in Treasuries that reset the rates market higher in a very short time period. The disorderly move higher in rates during June put a temporary halt in the grind, tighter for the spread sectors of the market. During the sell-off, we witnessed the uncommon pattern of higher yields and wider spreads. Our view is that the Fed’s motivation to begin preparing the markets for a reduction in the bond buying program was more driven by some frothiness in certain asset classes as opposed to significant progress being made on the economic front. While the markets had prepared for tapering to begin at the September FOMC meeting, the Fed once again shocked the market by leaving the program intact, citing a lack of confidence that recent economic progress could be continued and concerns over the budget “debate” in Washington. The action, or rather inaction, of the Fed put a bid back not only into the Treasury market but also the risk markets on the perception that easy money would be here longer than anticipated.

aiCIO: Two or three years ago, the average funding status was probably in the mid-seventies. I saw some studies that now it is breeching 90%. The current environment is good, if you were to ask corporate funds.

Fogarty: Absolutely. Funding ratios have benefited not only from a steady rise in their return-seeking strategies—equities and alternatives—but also from a significant drop in the present value of their liabilities as a result of higher corporate yields.

Wilson: Two years ago, on June 30, 2011, the average funded ratio was 91%; on August 31, 2011, however, the average funded ratio was 77%. Corporate DB plans lost 14 percentage points in funded status in just two months! What happened during this time period? We experienced a downgrade of the US government in a supreme loss of confidence after an ugly and ineffective debt ceiling debate, combined with a European debt flare-up. As a result, equities sold off dramatically and interest rates plummeted since, despite the downgrade, US Treasuries still remain the number one flight-to-quality asset class.

Now the average funded ratio, as of September 30, 2013, again stands at 91%, primarily due to robust equity performance and a rather sharp rise in interest rates. However, we’re also facing an eerily familiar and equally ugly debt debate process that threatens business and consumer confidence well into the first quarter of 2014.

The difference from two years ago to today is that only 25% of corporate plans had a glide path in place then versus about 75% today. Plan sponsors are in a much better position to take advantage of market opportunities to de-risk their portfolios, and we’re seeing definitive evidence of de-risking occurring.

aiCIO: Given your market views and the situation that corporations are in, is your baseline recommendation to extend duration?

Fogarty: It is our most common recommendation, for a few reasons. First of all, we predict that real yield will begin to track real GDP closer than it has over the past few years. We forecast real GDP increasing approximately 2.0% to 2.5% over the next three years. We also expect inflation to remain in check at around 1.5% to 2.0% for the foreseeable future. That results in approximately a 4% 10-year Treasury yield in two years. Given the current 10-year Treasury yield and our forecast for higher rates over the near term, why would we recommend corporate plans extend duration?

One reason is that corporate plans who have adopted an LDI mindset should hedge more of their liabilities while still taking advantage of rate increases on a net asset-liability basis as their funded ratios increase.

The other is a long-term technical reason. The US currently has about $21 trillion of retirement assets outstanding. The long-duration, US-dollar denominated, fixed-income universe stands at about $2.25 trillion. This enormous potential supply and demand imbalance could keep interest rates low and credit spreads tight over a long-term time horizon. Therefore, we believe there is an “early adopter advantage” in a sense for plan sponsors who allocate to long-duration strategies now.

aiCIO: Do CIOs, boards, and CFOs understand the first mover advantage?

Fogarty: Many do understand this phenomenon and are employing some interesting tactics to address the issue. For example, many plan sponsors are considering strategies where they can take long credit exposure but maintain a shorter duration position. One way to accomplish this is through the purchase of a long credit strategy in combination with interest rate swaps to bring the portfolio duration down to the desired level. The plan sponsor now owns the long credit assets, mitigating the looming supply issue, and can manage their overall duration positioning going forward.

aiCIO: In setting up an LDI program, establishing parameters and triggers seems to be the first step. Then, extending durations is the second step. What are the third and fourth steps you’re seeing?

Wilson: Each plan has its own journey, but in general terms, we see four distinct categories of closed or frozen plans. The first category is plans that are below 80% funded. They have three tools at their disposal to improve their funded status: investment returns, contributions, and rising interest rates. They need to earn outsized investment returns to gain ground on the liabilities. These plans are the least likely to extend duration and most likely to have large return-seeking portfolios. As a result, they are most prone to experiencing significant funded ratio and contribution volatility.

The second category is plans that have crossed the 80% threshold; they’re not close to their endgame funded ratio just yet, but they can see a path to get there. These plans often design glide paths and begin to extend the duration of their fixed-income portfolios, typically utilizing basic long government/credit or long credit strategies.

The third category, plans that are fairly well-funded—say 90% or higher, and may have their endgame funded ratio in sight—are extending duration in a more meaningful way at the expense of their return-seeking allocations. They are also often seeking a customized approach to more precisely hedge their liabilities and have adopted much more of a hedging mindset than the previous two categories.

Finally, the fourth category is for plans that are fully funded or overfunded and looking to aggressively de-risk. These plans are not only seeking investment-side solutions, but also liability-side solutions. Liability solutions include lump-sum offerings and buy-outs, among others. Lump sums are a fairly cost-effective way for plan sponsors to reduce their liability size—typically targeting terminated vested participants, but possibly retirees as well. Buy-outs are the ultimate endgame solution in that a plan sponsor can eliminate all future plan risk through the purchase of annuity contracts from an insurance company—for a price.

I firmly believe that an LDI approach, particularly a highly customized approach, goes hand-in-hand with these liability management options to form an overall portfolio of pension risk management solutions. 

aiCIO: One question in our survey this year was regarding pension plan endgames. Are buy-outs going to win the day, or is LDI going to continue its dominance through the end of the pension?

Wilson: I think it might end in a tie. There are many benefits to pursuing an LDI approach. The benefits include the ability to reduce the ultimate cost of the plan through investment returns and upward interest rate movements.

But many plan sponsors don’t want to spend an inordinate amount of time on their pension plan, especially as a wind-down business. LDI arguably is more efficient from a cost perspective, although I know many annuity providers who would have an argument with that. A lump-sum offering is an interesting option. You discount the pension obligations using a very similar corporate curve to the discounting curves that are used to measure either your balance sheet exposure or to quantify funding needs. So, lump sum offerings are a very efficient way to cut the tail off the liabilities. The big debate is how expensive or not buy-outs actually are.

I would argue that a buy-out is the most expensive option. However, it is an immediate and certain option, a type of risk-free option.

aiCIO: You’re paying to get rid of the pain.

Wilson: Yes.

Fogarty: And you’re paying a lot.

Wilson: I estimate the cost of an annuity buy-out is approximately 3% to 5% more expensive than managing the plan down over time. I should note that this premium is highly plan-dependent and assumes the liabilities are discounted using the PPA Spot Curve.

Therefore, the fundamental decision plan sponsors need to make is one of certainty of execution at a higher price—buy-outs—versus managing the plan down at a potentially lower ultimate cost while maintaining various risks, such as investment, longevity, and business opportunity cost—i.e. a distracted management team.

Many plan sponsors today are currently not motivated to write the big check required to execute a buy-out. As rates rise and funded ratios improve, it is likely a lot more buy-out activity will occur, but not as much as many market participants are calling for in my opinion.

aiCIO: What do you see for the future of the LDI business itself?

Wilson: Over the past three years, the acceptance and adoption of LDI has skyrocketed. So, the educational phase has essentially ended. Currently, almost nine out of ten plans are either practicing LDI to some degree or intend to adopt an LDI program.

If you’ve closed or frozen your plan, you have officially made the decision that you’re out of the pension business. You just haven’t acted on that yet if you haven’t implemented LDI.

I think the next five years will be quite fruitful for bona fide LDI providers. We project about $1 trillion of demand for long-duration bonds/derivatives over this time horizon.

aiCIO: What do you hear from plans who are closed or frozen, but don’t think in LDI terms?

Wilson: Most frozen and closed plans are very willing to adopt LDI. Those who are hesitant are generally significantly under-funded and/or concerned about extending duration in the face of rising rates.

aiCIO: LDI certainly seems to have won the argument.

Wilson: Yes, particularly as the case for LDI has been proven over the last dozen or so years. The volatility of return-seeking strategies, whether they are equities or alternatives, and the fact that they’re not correlated to pension discounting rates, has caused plan sponsors across the country a lot of pain in terms of funded ratio and contribution volatility. For example, over the past seven years, more than a half of a trillion dollars of contributions have been made to pension plans in the United States.

aiCIO: Have you done the math on [what would happen] if public plans were held to PPA standards?

Wilson: Yes, we selected a highly representative public plan—75% funded using a 7.65% discount rate—and recalculated their funded ratio using different discount curves. First, we estimated the impact of the pending GASB Statement No. 68, where public plans will be required to discount their unfunded liabilities using a high-quality municipal rate. This new methodology would lower their funded ratio to about 65% because their discount rate would blend down to 6.40%. Then, we quantified the impact of discounting the liabilities using the PPA Spot Curve, and the funded ratio dropped further, to 50%, because their discount rate dropped to 4.10% at the time.  Finally, we discounted their liabilities using a Treasury curve, which some are calling for, and found their funded ratio would be less than 40%.

aiCIO: Are public plans utilizing LDI?

Wilson: Under the current regulatory framework and given their economic situation, public pension plans have no real motivation to pursue LDI. Many plans are massively underfunded on an economic basis, using significantly higher discount rates than their corporate counterparts. They have three tools in the shed to improve their economic condition: contributions, investment returns, or plan reform.

Plan reform has been enacted by at least 30 states across the country, but it doesn’t have much of a near-term impact. Also, since many municipalities are budget constrained, making outsized contributions is a difficult proposition. So, large contributions will have to come from higher taxes or the issuance of pension bonds. Pension bonds are essentially a back-door way to raise taxes, so that’s very difficult.

That leaves investment returns. We’ve seen significant re-risking by some public plans in an effort to dig out of their holes. Public plans currently have about 70% of their portfolios invested in return-seeking strategies, such as equities and alternatives, and 30% in fixed income. Furthermore, given the consensus view that rates will continue to rise, we’ve seen a significant flight from core fixed income in favor of higher octane strategies such as high yield, bank loans, emerging market debt, and other “non-traditional” or “opportunistic” strategies.

On the contrary, we believe the primary role of the fixed income portfolio for public plans is to reduce portfolio volatility or immunize the liabilities. We’ve developed such strategies, which are “LDI-like” in that they seek to hedge liability payments over a defined time horizon and on a rolling basis. For example, a public plan sponsor can seek to immunize the next five years of plan payments, net of contributions, on a rolling basis with a high-quality fixed income portfolio. This strategy allows time for the return-seeking strategies to achieve their long-term expected returns and avoids the potential for a forced sale of assets to meet plan obligations, a situation we refer to as the “Black Hole Scenario”.

However, in our opinion, many public plan sponsors are increasing the risk profile of their fixed income allocation significantly, leaving themselves very overexposed to risk, with very little hedging properties left in their portfolios.

aiCIO: Going forward?

Wilson: We believe that LDI for public plans will be just as big as LDI for corporate plans—in a decade or so. Last summer, GASB issued Statement No. 68, which I believe is the first step towards a full blown PPA-like mark-to-market framework for public pension plans. GASB 68 says they can continue to discount their funded liabilities using an expected rate of return, but their unfunded liabilities need to be discounted using a high-quality municipal bond rate. If public plans, like their corporate counterparts, are “punished” for funded ratio volatility in the form of higher required contributions, LDI will emerge as an attractive solution.

Moody’s is also piling on by changing the way they evaluate the impact of the pension plan on the public sponsor’s credit rating. Essentially, they re-value the liabilities using the same discount curve as corporate plans, amortize the adjusted unfunded liability over a 20-year period, and include the new metrics in their ratings determination. Any resulting downgrades will likely increase the borrowing costs for the public entity. It is unclear if this particular development will motivate de-risking at some point in the future, but the trend towards more regulations and oversight is quite clear.