Despite the market volatility thus far in 2022, including the effects of the Russian invasion of Ukraine, US corporate plan funded ratios have been relatively steady year to date. The average plan is currently about 95% funded, down just slightly from 96% as of 31 December 2021. Discount rates are up about 70 bps this year, driving pension liabilities down and helping to offset losses in return-seeking assets, which we can proxy based on the 13% decline in the MSCI World Index.1
What can plan sponsors do to potentially preserve or enhance this stability while still pursuing longer-term funding aspirations? I’ll offer several thoughts here, including on rerisking, hedge ratios, and liability-hedging and return-seeking allocations.
This may not be the time to rerisk. The tragic situation in Ukraine introduces a wide range of potential outcomes, including de-escalation (ideal but unlikely), prolonged Russian occupation, a European or even global recession triggered by higher energy and commodity prices, and wider conflict. This uncertainty is compounded by the even more challenging path central banks must now travel to achieve a soft landing. We expect the Fed to move forward with tightening but at a more measured and data-dependent pace. Finally, the possibility of higher fiscal spending in the US and Europe to support domestic economies, especially on energy infrastructure and defense, introduces another variable, albeit a potentially positive one for growth.
While equities are more attractively valued than at the end of 2021 and may benefit from less aggressive central bank tightening, we think the geopolitical and policy uncertainties make adding to risk unappealing, especially given that equity markets entered the year at high valuations. In short, this may not be a “buy the dip” moment for DB plans focused on protecting their funded ratios. (As a reminder, we generally advocate against automatic rerisking when funded ratios wobble, instead preferring to add risk only when one believes the plan is being adequately compensated for it.)
As an aside, long credit spreads have widened from about the 20th percentile to just shy of the 50th percentile as of March 4, and members of our credit team, who have been conservative recently, say they have taken advantage of some credit risk opportunities but do not believe this is the time to add meaningfully to credit risk given geopolitical and policy uncertainties.2
Consider maximizing the hedge ratio — if not now, then via interest-rate or time triggers. Rising inflationary pressures brought on by commodity supply shocks may cause long maturity rates to move higher, but could be at least partially offset by lower growth expectations or flight-to-safety demand in the event of a growth shock or recession triggered by the geopolitical situation or the Fed needing to tighten more aggressively. This makes predicting long-term interest rates even more challenging than usual. There are a couple of options plan sponsors may want to consider:
- Maximizing the hedge ratio (for example, by using long Treasuries and STRIPS to lengthen duration in a capital-efficient manner) may help remove the uncertainty associated with trying to predict rates, reduce projected funded-ratio volatility, and mitigate unrewarded interest-rate risk. We generally think plans should consider using cash Treasuries/STRIPS to increase the interest-rate hedge ratio as far as possible before relying on synthetic sources of duration, such as Treasury futures and interest-rate swaps. We believe these unfunded instruments, when prioritized over physicals and used in excessive notional size, may introduce cost and complexity to a portfolio, which can erode some of the benefits. Interest-rate swaps are now being priced off of SOFR rates, as opposed to LIBOR, which introduces an additional layer of complexity in quantifying the true cost of unfunded duration.
- Triggers that incrementally extend duration at specified interest-rate levels or time intervals can provide a path for plans that want to reach a higher strategic hedge ratio but seek to take advantage of any near-term potential for higher inflation expectations to filter into higher rates.
Be prepared to take advantage of any upside equity or rate volatility via a glidepath. As the market tries to discern outcomes in the geopolitical crisis and in the central bank and fiscal policy response, expect equity and rates volatility to persist. Plans may be able to take advantage of any upside volatility with a glidepath that systematically derisks as the funded ratio improves. We think plans that have glidepaths in place should stay disciplined about derisking in accordance with established funded-ratio triggers.
Consider holistic liability-hedging portfolio construction. Our research shows that plans that have an equity-dominant asset mix can potentially reduce projected funded-ratio volatility, with limited to no effect on projected funded-ratio return, by emphasizing Treasuries over corporate bonds in the hedging portfolio. This is a function of the positive correlation between equities and corporate bond excess returns. Plans can then incrementally add to corporates as the plan’s equity or return-seeking allocation declines along the glidepath. Plans might also consider alternatives to corporate bonds that can potentially provide downside mitigation when spreads widen, such as long-duration securitized assets. For more details, please see our paper, The evolution of derisking: Assessing new and time-tested liability-hedging ideas.
Diversify the return-seeking allocation. Plans that have equity-centric return-seeking portfolios could consider adding defensive equities that aim to outperform in down markets (e.g., dividend-oriented or cash compounder strategies) and diversifiers that may potentially provide more explicit downside mitigation, such as infrastructure, real estate, return-seeking fixed income, and low-beta, net-long hedge funds. In addition to lower expected beta, infrastructure and real estate offer the potential benefit that results from owners of these physical assets being able to adjust customer pricing in response to higher inflation. Renewables-related energy infrastructure, already a favorite theme of ours as the world transitions to cleaner sources of energy, may be compelling given the need for Europe to reduce its dependence on Russian energy. As my colleague Jackie Yang pointed out in our recent “end-state” webcast (see the replay here), these diversifying strategies have shown the potential to outperform in times of market stress but have lagged core equities since the onset of the pandemic in March 2020, which could make this an attractive entry point for such investments.