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.
