For this article we will try to put ourselves in your shoes, imagining you have 10 minutes to communicate with your board. Below, based on our clients’ experiences in 2020, we highlight a hypothetical pension plan’s issues and what we believe your board would need to know.
2020 was a tumultuous year for pension funding and our plan did not escape the disruption. Our month-end funded status fell from 90% at the start of the year, to a low of 81% during the year – before bouncing back to an expected 85% at year-end. Our deficit in dollar terms, however, increased by more than 55% as the present value of our liabilities have increased as plan discount rates fell1.
Things could have been much worse were it not for the Fed’s intervention in markets – so we view 2020 as a health-warning for our pension risk-management strategy. We believe we should refresh our strategy now while our deficit is still ‘solvable’ as an investment objective rather than risking the target return increasing to unattainable levels. This will help us to avoid unplanned contributions, consistent with our long-term corporate goals.
Funded status and liquidity risks are growing
As our plan is now closed to new participants – year by year we are paying more assets out in benefits and lump sums than we receive in contribution and investment inflows.
Figure 1: Our evolving pension investment challenge2
‘Forced’ selling of assets to meet benefit payments is therefore a rising consideration and is an area we wish to address in 2021. Forced-selling risk became very real for us in Q2 2020 when markets suffered an unprecedented liquidity freeze – and selling even US Treasuries became challenging. So, to meet our benefit payments we had to sell what we could, including liquidating a portion of our equity position at market lows.
This exacerbated another challenge we face in closing the funding gap – as our assets are increasingly being spent down to meet obligations, it is becoming harder to compound the returns needed to close our funding gap.
As a result, we have been spending more time understanding how we can protect our return streams and to have a much more pre-planned liquidity strategy for the future.
Three key LDI challenges for us to address in 2021
Low yields – a lower hedge ratio may be riskier than we thought
As you recall, we started 2020 with an ‘under-hedged’ liability interest rate position, to ‘wait for rates’ to rise, with the goal of improving the plan’s funded status. Higher interest rates help because the present value of our liabilities will fall if rates rise, all else equal, and vice versa if rates decline. However, this investment position did not work out. Although rates started the year around record lows, our projected discount rate fell yet again by ~50bp over the year. This increased the value of our liabilities by ~6%1.
Looking forward, we cannot ignore the possibility that rates will fall even further and are therefore looking to preserve and increase our hedge ratio. While implementing a higher hedge ratio might seem counterintuitive at first in a world in which yields have never been lower, we believe this will greatly help us to stabilize our funding gap and ensure that we can be confident that we can continue to invest our way out of our current deficit position.
We have also looked at the experience of Europe and Japan – where long duration corporate bond rates (the equivalent our GAAP discount rates) are close to 2% lower than here in the US. If rates fell here to that degree, our dollar liabilities could increase by another 20% to 30%, or more, and mean that we may need to make unplanned contributions.
Searching for yield is ever-more challenging
The low-yield environment also challenges us on the asset side of our pension balance sheet. Many investors are reaching down the capital structure and assuming higher credit risks to generate higher expected returns. We do not concur with this approach and are concerned that the potential for higher returns may not be realized. This is because we view the economic shutdowns in 2020 as a tipping-point for the global economy, likely to lead to a large increase in future defaults.
Instead, we believe there is a better, lower risk way, to generate returns and to protect the plan’s funded status. This involves optimizing our portfolio to be more capital efficient, staying high in the capital structure and matching our bond inflows closely with liability outflows. The benefits of this approach are that more plan assets are available to invest into higher quality credits, the ability to increase returns by targeting available ‘illiquidity’ premia and investing without adding forced-selling risks.
Our approach to diversification will need to evolve
Our pension plan has previously looked to Treasuries and other fixed income assets to provide strategy diversification and to act as hedge against our equity tail-risk exposure. But something seemed to change this year as equities and fixed income sold off together during episodes of market volatility.
This is causing us to pose the question: “What if we can no longer rely on bond markets to act as ballast when equities decline?” This is not something we can afford to get wrong as the implications could materially influence our investment outcome.
Therefore, we are looking at controlling downside volatility and the risk of large, sudden asset drawdowns in a much more direct way – with ‘tail-risk’ strategies designed to be there when diversification is not. These strategies do not come free but can be now be implemented using a much more dynamic and intelligent process to reduce long-term program costs.
Closing remarks: shifting to an ‘outcome’-focus
Let me finish by saying that solving our deficit challenge is an ongoing process. Our plan assets will continue to run-off while our required rate of return will remain sensitive to our funded status level. As such, we will need to continue to manage more liability risk and evolve as well as to enhance our approach to generating returns. Our focus as an investment team however remains unchanged. We are confident that our areas of focus for 2021 will serve us well for many years to come and ultimately give us the best chance to maximize the certainty of meeting the financial outcome we are seeking.
2For illustrative purposes only