Pension De-Risking’s Next Wave

How to minimize risk at a time when persistent low interest rates have left many pension plans underfunded.

PIMCO has been helping defined benefit funds meet investment challenges and risks for more than 40 years. Chief Investment Officer spoke with PIMCO Executive Vice President Rene Martel, head of the firm’s pension solutions strategies, to discuss how the firm is helping plan sponsors at a time when persistent low interest rates have left many pension plans underfunded and searching for ways to minimize risk. Q: PIMCO is renowned for its fixed-income expertise. How does this translate into offerings for pension plan sponsors? Rene Martel: Our expertise across the entire market spectrum, has enabled us to develop pension solutions that are both flexible and holistic. We can move from one market to another as appropriate, and develop pension strategies that evolve as client circumstances and market conditions change and new investment instruments become available. We focus on the relationship between the asset owner’s entire portfolio and liability because the variables our clients care about—their plan’s funding ratio, contributions to their plan, accounting implications—are driven by the behavior of the total plan assets relative to liabilities. Q: How does all that fit together in the real world? Martel: Here’s an example. An underfunded plan sponsor early in its de-risking glidepath might be attracted first to our successful track record managing long-duration portfolios with a broader opportunity set and alpha potential. As its funding position improves, it may benefit from our expertise in managing a highly customized liability-driven investment (LDI) portfolio. Meanwhile, you could have a plan sponsor closer to its end state benefit from our research on end-state liability immunization portfolios, or what some call hibernation. Or it could be interested in our track record managing insurance company assets if it’s contemplating a buyout. You can overlay all this with PIMCO’s pioneering position in the derivatives market, which has served clients who engage us in completion management capacities. Q: How has pension de-risking evolved over the past decade, and how has PIMCO kept pace? Martel: The typical LDI strategy today has more credit bias and is more customized and dynamic than it was in the mid-2000s. We believe plan sponsors need a de-risking strategy that evolves over time, which is why we have a focus on innovation and evolution, and try to anticipate change. For example, when the big LDI migration toward credit started around 2008 in the aftermath of the financial crisis, we had already begun to position our strong resources in the credit space to apply them in LDI and quickly help clients transition their portfolios. Today, we continue to work on innovative implementation strategies to help sponsors reduce the operational complexity, burden and risk of glidepath execution, and to help them in their efforts to swiftly lock in funding-ratio gains. Q: How will de-risking strategies tomorrow differ from what we’re seeing today? Martel: There will be a focus on becoming more agile, partly because opportunities to de-risk have often proved to be short-lived. Think of the taper tantrum, where for a few months you had rates move much higher, then revert relatively quickly. We’re working to put plans in position to take advantage of those opportunities. One way is to “pre-fund” your glidepath triggers by shifting your physical portfolio right now toward what you want it to be in your end state, and use a derivatives overlay to bring you back synthetically to the allocation you want today. Then, as your funding ratio improves, all you have to do is adjust the derivatives position. That’s much faster and less costly than transitioning a physical portfolio. We’re also suggesting that plans consider maintaining a meaningful degree of active risk in LDI portfolios. Matching your LDI portfolio to your liabilities, but allowing more freedom for active management to potentially outperform them, lets you reach your return target without allocating as much to return-seeking assets—and leads to a much lower risk exposure relative to liabilities. CIO: Are there any other new strategies plan sponsors might want to consider? Q: Are there any other new strategies plan sponsors might want to consider? Martel: In addition to completion management, I’ll mention liquidity management. Amid concerns about liquidity in the fixed-income markets, clients are asking how they should prepare to meet benefit payments in the short run—the next three to four years. We’ve worked with clients to create corporate-bond ladders and crossover corporate ladders using a combination of high-yield and BBB bonds to match their liability cash flows. This can potentially generate yields 200 to 250 basis points above the discount rate applicable to those first few years of cash flow. You’re essentially defeasing a portion of your liability with a lower amount of assets than the value of that liability, and of course, the potential for higher yield comes with greater risk. Q: What should plan sponsors be thinking about as they approach their de-risking end state? Martel: For many sponsors it is difficult to predict what end state will best match their risk tolerance several years from now, so we’ve developed a default starting point. For closed plans that have limited or no benefit accruals going forward, we suggest working toward an end-state funding ratio of about 110% while targeting a 5% funding-ratio risk. With that combination, you can go through a two-standard deviation event, which would be pretty bad event—think 2008—and still be fully funded. Plans can usually achieve that funding ratio risk with a 70% to 80% allocation to LDI in the end state, leaving room for a 20% to 30% return-seeking allocation that may help sponsors overcome unforeseen risks such as longevity improvement.
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