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LDI Alert — Time to prepare for a “clear skies” environment?

Bill Cole, CFA, CAIA, Fixed Income Investment Director
Connor Fitzgerald, CFA, Fixed Income Portfolio Manager
2022-01-31
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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.

THE AVERAGE FUNDED RATIO FOR CORPORATE DB PLANS FELL FROM 87% AT THE BEGINNING OF 2020 to 77% in the depths of the COVID-induced market sell-off in March, and then climbed all the way back to 88% by early January 2021.1 As the market adapts to a new political administration and eagerly awaits the widespread rollout of the COVID vaccines, many are left to wonder: What’s next for funded ratios?

The recent strong rebound puts the average plan’s funded ratio a few percentage points below the post-GFC high-water mark we saw in 2018 (in the low 90%s). It comes at a time when the average plan’s asset allocation is split approximately 50/50 between liability-hedging fixed income and return-seeking assets. This leaves plans positioned to potentially benefit from what we call a “clear skies” environment — where positive equity returns grow plan assets and rising rates drive down plan liabilities. While the distribution of potential market outcomes remains wide, we believe we may be approaching such an environment, which could move plans’ funded ratios toward their next derisking trigger. However, this opportunity may be short-lived.

Our outlook

We are still in the early innings of the recovery from the pandemic-driven recession. The markets and the economy have received unprecedented levels of fiscal and monetary support. We believe significant pent-up consumer demand will be unleashed in the second half of the year as the vaccine roll-out progresses. This demand could be particularly powerful in the service sectors, with a strong multiplier effect on employment. Robust consumer spending, coupled with a pledge from the Fed not to raise rates until inflation is running comfortably at or above its 2% target, means the long end of the Treasury curve could serve as the release valve for this upward pressure on rates.

Markets are usually a leading indicator for economic growth and profits. In our view, growth-sensitive and inflation-sensitive equities have already moved aggressively higher to reflect this story line (although value stocks have not participated as fully). US Treasury yields, however, have lagged — likely because of the overwhelming market presence of the Fed, which is still buying $80 billion of Treasuries every month. While we expect the Fed purchases to continue at this pace for the foreseeable future, the combination of better growth and significant Treasury issuance could counteract this technical, helping long-end yields “catch up” to growth- and inflation-sensitive assets (Figure 1).

FIGURE 1

a-fleeting-clear-skies-opportunity-for-corporate-plans-fig1.svg

We see risks, though, that this positive environment for funded ratios could be fleeting. For one, higher funded ratios can elicit demand for fixed income from plan sponsors as they hit glidepath triggers and derisk, which in turn can push yields lower. Higher yields may also draw in other yield-based buyers.

Additionally, in the current environment, where sovereign balance sheets have ballooned to provide support to the markets and the consumer during the pandemic, the increased debt load could make the world more sensitive to higher rates — meaning that higher rate structures could become self-defeating and choke off a recovery in growth. Higher rates could have negative consequences for equities, especially if rates rise quickly, or if investors fear that a recovering economy and higher inflation will lead the Fed to eventually become less accommodative.

What can plan sponsors do to prepare?

  1. Consider monitoring funded status more frequently. Many plan sponsors calculate funded status monthly or quarterly. We believe that monitoring funded status frequently — daily, if possible — can allow plans to potentially monetize large intra-period gains in funded status.
  2. Plan the next derisking move in advance. As we’ve noted, any potential improvements in funded status driven by higher rates/equities could be short-lived. It is important to have processes in place so that capital can be allocated quickly to potentially lock in funded-status gains.
  3. Consider adding interest-rate triggers to a glidepath or recalibrating interest-rate triggers to reflect current levels. In the event that we enter a clear skies environment and funded ratios improve but not to the point where plans reach their next derisking trigger, interest-rate triggers may provide a systematic way to extend duration in order to help protect funded-status gains. Rather than waiting for rates to reach a long-term “fair value” to derisk, plans may want to consider setting triggers based on incremental movement off current rates — e.g., extend duration incrementally for every 25 bp rise in long-term Treasury yields.
  4. Consider derisking return-seeking assets. We think it’s important to have a plan for reducing and potentially repositioning return-seeking allocations as derisking continues along the glidepath. Plans may want to consider gradually emphasizing more defensive equity and lower-beta “bridge” strategies (e.g., REITs, public infrastructure, credit sectors/opportunistic fixed income), with core equities as a funding source. Recognizing that the clear skies scenario may not persist and equity valuations remain elevated, we think more defensive equities that have some correlation with plan liabilities (e.g., REITs and public infrastructure) may be attractive on a relative basis.

Want to learn more from our LDI team? Visit our LDI page.


1Wellington Management estimates based on Russell 3000 companies. Based on estimated changes in yields and asset returns since reported funded ratios and discount rates at year-end 2019. For illustrative purposes only.

Please refer to this important disclosure for more information.

Authored by
Bill Cole
Bill Cole, CFA, CAIA
Fixed Income Investment Director
Boston
Connor Fitzgerald
Connor Fitzgerald, CFA
Fixed Income Portfolio Manager
Boston

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