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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Jacqueline Yang: The average US plan funded ratio was at 94% at the end of November 2021, up from 88% at the end of 2020. Most of the gain occurred in the first quarter of 2021, driven by higher discount rates and strong equity performance. In response, we saw a lot of derisking activity. Plans also seemed more disciplined about derisking this past year, with very few talking about rerisking. Looking ahead, we think funded ratios will have to leg up to about 100% or so for the next wave of derisking to take hold.
In terms of ROAs, we have seen assumptions continue to notch down. The average assumption for US plans was 6% as of year-end 2020, about 30 basis points lower than the prior year. And, given the derisking activity I just talked about, we expect this to continue to trend down. We provide more detail, including our long-term capital market assumptions, in our new 2022 ROA guide.
Jake Brown: We think these derisking moves offer an opportunity to evolve a plan’s return-seeking allocation. Specifically, we believe that diversifying the return-seeking portfolio can create the potential to reduce funded-ratio volatility while still allowing for some upside. Figure 1 compares three mixes. Mix 1 is a traditional 60% core equity/40% long bond mix. In Mix 2, we diversified the core equity exposure by shifting 20% each to core, defensive (95/85 upside/downside capture ratio), and diversifying strategies (a blend of infrastructure equities, REITS, and return-seeking fixed income). The effect of diversifying core equities into these exposures, as shown in the statistics below the pie charts, was to reduce risk as measured by funded-ratio volatility, while maintaining or even adding a little to funded-ratio return.
For comparison, we included Mix 3, which represents a more traditional blend of 50% core equities and 50% long bonds; this represents a 10% derisking move from the 60/40 Mix 1 portfolio. Comparing results for Mix 2 and Mix 3, Mix 2 achieved a similar reduction in funded-ratio volatility to Mix 3, but Mix 2 retained more upside potential.
Jake Brown: Alternatives have been a growing topic of interest in our discussions with plan sponsors, with two particular areas of focus. The first is liquid and lower-beta hedge funds, which may play an effective diversifying role via lower correlation to core equities while still having potential to outperform the liability and therefore improve funded status over time. The other area is private equity, which we think can potentially play a role as a core allocation within the return-seeking portfolio. But we also think plans have to be very aware of the liquidity terms — particularly plans that are actively derisking. Given the less liquid nature of private assets, as return-seeking allocations shrink, privates can become a proportionately larger share of the portfolio. One way to mitigate this risk, though not eliminate it, may be to focus on later-stage privates, where lockups may be shorter, or private credit.
Amy Luberto: To answer that, it’s important to note that we focus on three key risks of a plan’s liability when assessing a proper fit for the LDI benchmark. In order of importance, they are interest-rate risk, credit risk, and yield-curve risk. I’d also emphasize that we measure credit risk in the liability and LDI benchmark using duration times spread or DTS, which we think better captures the fact that lower-quality bonds exhibit a higher level of spread volatility than higher-quality bonds. The DTS of the liability is really what drives the balance between investment-grade corporate bonds and US Treasuries. We blend those two in such a way that the DTS of the benchmark is close to that of the liability. With all that said, we find that the sweet spot for corporates and Treasuries tends to be something close to the 75%/25% split shown in Figure 2.
As we note in Figure 2, US Treasuries offer a dedicated liquidity source for benefit payments or other expenses and may be particularly important for plans that pay lump sums. In addition, Treasuries may provide an efficient way to adjust the portfolio’s duration over time. In terms of the investment-grade corporate bond allocation, we think plans should consider utilizing the full investment-grade corporate bonds universe, inclusive of BBB-rated bonds. Some plans prefer to use A and up indices, but that cuts the opportunity set in half. We think using the full opportunity set can help improve issuer diversification and allow the portfolio management team more flexibility. (Read more about this topic in our paper, “The evolution of derisking: Assessing new and time-tested liability-hedging ideas.”)
Amy Luberto: Long-duration securitized (LDS) assets may offer diversification versus corporate credit risk — and specifically, downside protection in a credit sell-off. The goal is for these assets to move similarly to the liability, as part of the liability-hedging portfolio, but at the same time, we don’t want them to move in the exact same way as corporate bonds in order to achieve some level of diversification. We think LDS may thread that needle pretty well, having historically had a fairly strong positive correlation with long corporate bonds in terms of both total returns and excess returns, while also leaving some room for diversification. In particular, LDS has tended to outperform corporate credit during spread widening events. We also believe that expanding the liability-hedging opportunity set with LDS can potentially help offset concentration risk in certain corporate indices and enhance credit quality and liquidity versus some corporate bonds.
Amy Trainor: Private placements are typically investment-grade fixed-rate debt, issued across the maturity spectrum including at long durations — characteristics that may align with what plans are looking for in liability-hedging strategies. And I do believe that private placements can potentially play a role. But I’d also recommend that plan sponsors do their homework. For example, what are your expectations for a liquidity premium and how much risk are you willing to assume in pursuit of it? The yield premium over public corporate bonds can vary widely, depending on quality, risk profile, and subsector. In addition, how comfortable are you with a buy-and-hold position in an illiquid bond? Anecdotally, we’ve noticed plans targeting the 5- to 10-year maturity range in private placements, which might reflect liquidity concerns.
Bill Cole: Interest in the 1-year to 10-year segment of the credit market has risen, particularly among closed and frozen plans. With liabilities that are shortening each year and liability-hedging allocations that are growing as a result of derisking, these plans find they have less need for capital-efficient sources of duration and spread duration to hedge their liabilities. Figure 3 shows how a liability-hedging allocation might evolve as the liability shortens over time.
For plans that have historically used long credit as the primary hedging allocation, there are a few noticeable differences within the intermediate segment of the market. For example, the intermediate segment is about twice the size of the long end of the market and it’s more liquid. As a result, transaction costs may be more manageable. The sector composition of the intermediate market is also quite different, with more exposure to banks and less to utilities, for example.
I’d also note that there are differences between the intermediate credit and the intermediate corporate indices. The intermediate credit index includes the government-related sector (e.g., sovereigns, supranationals, and taxable municipals). This sector is not represented in most plan discount rates, which is why we think an intermediate corporate index may be a better liability hedge.
Finally, within an intermediate allocation, we think that expanding the opportunity set with high yield and securitized may help to diversify corporate credit risk and pursue incremental alpha without compromising the risk profile of the portfolio. We believe these markets are more relevant for an intermediate portfolio than a long-duration portfolio because their duration and curve profiles closely resemble those of intermediate credit.
Louis Liu: As Amy mentioned, in LDI the focus is on interest-rate and spread exposure. In cash-flow driven investing (CDI), as the name implies, the focus is on aligning cash flows from coupon income and maturing securities with anticipated benefit payments. We can think of CDI as a more precise form of LDI. That said, we don’t think there’s a single point at which CDI becomes the better choice; rather, the decision is typically based on a range of considerations. For example, CDI is generally most appropriate for plans with fairly stable and predictable cash flows. That means CDI might be a good choice for frozen or inactive plans, but less so for open plans and plans that pay large lump sums. Plans also need to be well funded because CDI is an asset-heavy strategy. Finally, CDI tends to be well suited for plans that are highly cash-flow negative.
It’s also worth noting that CDI can be implemented for just part of a plan — retirees in the plan, for example. It may also play a role in a plan’s end-state asset allocation, as a component of a “hibernation” strategy.
Amy Trainor: As a reminder, in a cash-balance plan, each participant has a notional account balance, and that balance grows each year at an interest-crediting rate that’s defined by the plan. The most prevalent plan design sets that rate based on the 30-year Treasury bond yield. The challenge with this design is that you have a riskless liability that’s earning interest above the risk-free rate, so you can’t technically hedge the liability. But we do believe that a plan can track it closely. The allocation shown in Figure 4 offers an example. The 50% allocation to income-generating assets would be intended to keep pace with the interest-crediting rate. There’s an emphasis on higher quality, while allowing the potential to enhance return with opportunistic allocations. The other half of the mix, with allocations to agency mortgage-backed securities and short-maturity government bonds, has two roles: 1) capital preservation, again going back to the riskless nature of the liability, and 2) liquidity, recognizing that most cash-balance plans allow lump-sum distributions. We look at the historical results of such an approach in our paper, “Cash-balance liabilities: A new investment framework.” We also discuss different approaches to the interest-crediting-rate design, which may require different investment solutions.