Fighting downgrade drag to reduce pension liability lag

Amy Trainor, FSA, Multi-Asset Strategist
Louis Liu, CFA, ASA, MAAA, Fixed Income Quantitative Strategist
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Key points

  • Even robustly constructed liability benchmarks face headwinds that can prevent them from keeping pace with the liability, including spread basis risk, index methodology mismatches, and, most critically, the “drag” caused by credit-rating downgrades of issuers in the benchmark.
  • Several steps may help mitigate downgrade drag, including seeking to avoid downgrades via strong security selection, diversifying and prudently sizing positions, limiting forced selling of downgraded bonds when justified by fundamentals, and allowing managers to use tools at their disposal (e.g., sector rotation).
  • Plans may also want to consider long-duration securitized assets, which may offer diversification benefits in a liability-hedging strategy.

CORPORATE DEFINED BENEFIT (DB) PLAN SPONSORS ARE INCREASINGLY FOCUSED on how the construction of their liability-hedging portfolios can be enhanced to improve the probability of simply meeting the growth in their plan’s liability. In particular, plan sponsors are worried about the effect of credit-rating downgrades on their liability-hedging portfolios and funded ratios.

In this paper, we outline the challenges of constructing a portfolio that can keep pace with the liability and propose a set of practices we think plans and their LDI managers should consider to help combat what we call “downgrade drag,” including avoiding downgrades through security selection, mitigating their impact through various forms of diversification, and allowing managers to use all the tools at their disposal to try to outperform.

Defining the problem

In designing a liability-hedging portfolio, the focus is typically on identifying the key risk characteristics (e.g., related to interest rate and credit risk) of the liability and then building a liability benchmark with similar risk characteristics. The liability benchmark is intended to be an investable representation of the plan’s liability, typically customized by blending various fixed income indices. However, even the most robustly constructed liability benchmark faces…

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Past performance is no guarantee of future performance and can be misleading. Funds returns are shown net of fees.
Source: Wellington Management

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