1. Why would a plan consider using LDI today if the plan is underfunded and rates are low?
Trainor: Waiting for rates to rise can actually be costly. Let me explain. Most plans today are underhedged versus their liability, with a hedge ratio around 40% − 45% being fairly typical. There’s an expectation that if rates rise, the plan’s funded ratio will benefit from being underhedged. While that should be true if rates rise rapidly over the short term, it’s less clear that it will be true if it takes longer for rates to rise.
For example, if rates go up 100 basis points tomorrow or even over the course of the next year, then it would seem likely that the typical underhedged plan (again, a hedge ratio of 40% − 45%) would enjoy a meaningful benefit to its funded ratio. But if it takes five years for rates to go up 100 basis points, that same plan’s funded ratio could actually experience a small decline. While it may sound counterintuitive that rates could go up but the funded ratio could decline, this can be chalked up to the fact that the liability’s yield would have accrued and compounded over that five-year period, offsetting the benefit of higher rates.
We think that this can be a useful lens through which to view the liability-hedging decision: quantifying how much rates need to go up over a particular time period in order for a plan’s funded ratio to benefit from being underhedged. In terms of implementation, one action step might be to add interest-rate triggers to a plan’s glidepath—in order to systematically extend duration and increase the hedge ratio as rates rise. That may help to avoid the erosion of any funded-ratio gains arising from short-term rate movements.
2. Do plans need to customize their liability-hedging allocation?
Cole: We think a little bit of customization can go a long way. Our research suggests that plans may be able to achieve their desired level of funded-ratio volatility by blending standard market indexes in a manner that targets an appropriate level of interest-rate and credit risk. We have found that a benchmark with 75% long corporate bonds and 25% long government bonds could suit plans with a liability duration of about 13 or 14 years, though of course every plan’s specific needs will vary.
On a related note, we are often asked how important it is to match the key rate durations of the liability cash flows across the curve. The modeling we’ve done suggests that precisely matching the durations can introduce a lot of cost and complexity—when adding synthetic overlays, for example—and that there may not be a big benefit to funded-ratio volatility in return. Again, this suggests that plans may want to avoid over-engineering their liability-hedging benchmarks.
In addition, the right mix will depend on where a plan is along its glidepath. A plan might tilt the allocation more toward government bonds earlier on the glidepath, when it holds a high allocation to equities, and then gradually move toward a more corporate-centric, custom approach as it derisks. Generally, we think plans should consider the use of customization once liability-hedging assets approach roughly 75% of the portfolio.
3. For plans that derisk and want to diversify some of their long corporate bond exposure, are there any alternatives?
Liu: Our research suggests that high-quality, long-duration commercial mortgage-backed securities (CMBS) could be a viable alternative to long corporate bonds in a plan’s fixed income allocation, given the CMBS sector’s growing size, relatively stable cash flows, and low default risk. For plans with allocations to equities, adding high-quality CMBS may also help reduce funded-ratio risk at the plan level, because these securities may be less correlated to equities than corporate bonds may be.
It’s understandable that plans shifting allocations from equities to fixed income typically focus on high-quality, long-duration corporate bonds. They can potentially provide steady, high-quality cash flows that can be used to pay claims when they come due. But as more plans derisk, corporate bond issuer concentration risk can become an important risk factor to consider, and it may be wise for plans to look for opportunities to diversify—particularly larger plans.
4. Should a glidepath be for derisking only, or should it also allow for “rerisking”?
Trainor: Sponsors who use glidepaths often wrestle with this issue: If a plan’s funded ratio falls after the plan has derisked, should the plan add back to return-seeking assets and reduce the liability hedge? Our research has found that this type of automatic rerisking is not without risks of its own, as there are situations where it can exacerbate funded-ratio drawdowns. If the market takes an extended period to mean-revert, for example, rerisking can mean buying equities and selling long bonds during a protracted equity sell-off and bond rally, when the plan’s funded ratio is already suffering. We therefore generally advise against automatic rerisking.
But if automatic rerisking is off the table, what alternatives does a plan have if it wants to increase return potential? One alternative is to adopt “smarter” rerisking strategies that evaluate return opportunities and add risk only if those opportunities are attractive. Another is to bypass rerisking altogether and simply design a glidepath that derisks at a slower pace.
5. How should plans think about using STRIPS and derivative overlays, such as Treasury futures and interest-rate swaps, in their liability-hedging allocation?
Cole: We see pros and cons with each of these options. STRIPS may help a plan pursue its objective with minimal complexity, but the market is relatively small and security selection is critical. The Treasury futures market is very liquid, but futures need to be rolled quarterly and can take time to implement in size. The interest-rate swaps market is large and liquid, and may be a good choice for plans that want to target very specific yield curve exposures. One current disadvantage we see is that swaps are expensive relative to Treasuries, due to a supply/demand imbalance. We think there is an underappreciated risk that this relationship between swap rates and Treasury yields could normalize, which could erode a plan’s funded ratio. For example, swap rates could normalize if regulation paves the way for a centrally cleared repo market, providing an alternate avenue to obtain this type of exposure.
In choosing one of these tools, plans may want to consider the source of funds they intend to use to extend duration. STRIPS may be a logical first step for a plan that is going to sell return-seeking assets to fund the duration extension—the STRIPS may provide a meaningful pickup in duration compared with a return-seeking asset. On the other hand, a plan that is just looking to get a little more duration out of a modest existing fixed income portfolio may find that STRIPS don’t significantly boost duration at the total plan level and that synthetic options might be the best route.
6. How can a completion manager contribute to an LDI strategy?
Cole: We think a completion manager can play a valuable role within an LDI construct. As I noted, when it comes to constructing a liability-hedging benchmark, we think a little bit of customization can go a long way and that targeting a few key risks—namely the overall level of interest-rate and credit risk—may help substantially reduce funded-ratio volatility. One key role a completion manager can play is aggregating the risk exposures of the liability-hedging benchmark and building a complementary portfolio that could help align the levels of interest-rate and credit risk with the plan liability and the target hedge ratio—what you might think of as the final piece of the LDI puzzle.
Trainor: Completion managers can also partner with plans on their derisking glidepath. They can assist with designing the glidepath, measuring the funded ratio, monitoring progression along the glidepath, and actually implementing the derisking allocation.
7. Are there different considerations when designing an LDI strategy for a cash-balance plan?
Liu: Yes, a cash-balance plan is very different from a traditional pension plan. In fact, it behaves a bit like a bank deposit. At the beginning of the year, you know your account balance. Over the course of the year, the plan gives you a guaranteed crediting rate, and your cash balance grows by that amount. The crediting rate is typically something like the yield of the 30-year Treasury bond at the beginning of the calendar year. This means that many cash-balance plans pay interest at a long maturity yield, but have almost no duration—i.e., there is no natural hedging asset to meet such requirements, as there is with a traditional plan (where long corporate and government bonds typically play the hedging role). In addition, cash-balance plans are usually portable when participants change jobs, so liquidity is important.
Pursuing the desired combination of liquidity, yield, and duration may require a combination of assets, possibly including short-duration Treasuries, mortgage-backed securities, broad-market investment-grade credits, and spread sectors such as high yield and bank loans. In our research, we have found this to be a potentially effective means to track to a cash-balance liability. Cash-balance provisions vary from plan to plan, however, so it’s important to conduct a detailed assessment of the best strategy for each particular plan.
Trainor: It’s also important for a plan that has a cash-balance liability to think about how it should be hedged at the total plan level. The answer typically depends on two factors. First, what percentage of total plan liability risk is attributable to the cash-balance plan? And second, how much is the plan currently holding in liability-hedging assets? If the plan also has a legacy traditional formula, hedging that traditional plan liability should generally be prioritized over hedging the cash-balance liability. This is because the traditional plan liability will dominate the funded-ratio volatility due to its higher volatility. But over time, cash-balance liabilities may grow and make up a larger proportion of the plan’s liability risk. At the same time, plans might increase their liability-matching allocation as they derisk. As those two variables converge, it may become important to have a more refined cash-balance tracking strategy along the lines that Louis described.
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