AMID A RECENT CONFLUENCE OF CONDITIONS—CORPORATE TAX CUTS, RISING RATES, IMPROVED FUNDED STATUS, INCREASED PBGC1 PREMIUMS— PENSION PLANS ARE LOOKING TO DE-RISK AND/OR MAKE NEW PLAN CONTRIBUTIONS. BUT THEY MAY NOT BE FULLY AWARE OF ALL THE NUANCES INVOLVED.
For an investor’s perspective, we sat down with members of the Multi-Asset Solutions team at J.P. Morgan Asset Management. The team discussed the issues pension plans should consider in the current investing, tax and regulatory environment. When plans de-risk, the team notes, they typically focus on their growth assets and equity risk. They often focus less than they should on the risk embedded in their hedge assets, specifically the risk that comes from owning corporate credit at this stage of the credit cycle. The team examines that issue, among others, in the following Q&A:
Q: WHAT TRENDS ARE YOU OBSERVING IN YOUR WORK WITH PENSION PLANS?
A: Maddi Dessner, Head of Investment Specialists Americas — There are two dynamics at play. The first relates to markets. In the past 18 months, equity markets and risk assets generally have moved higher and interest rates have backed up. As a result, average funded status for U.S. corporations has improved, from a post-crisis low of 77% in 2012 to 86% at the end of 2017, with a clearly improving trend through 2018. The second dynamic relates to lower corporate taxes that took effect in January1, giving plans an incentive to make a contribution before September 15 and thus get a tax write-off at the higher rate. And as funded status improves, plans will reduce their obligation to pay PBGC premiums, which in 2018 are set at a higher per participant rate. All in all, many plans are asking, Should I be on a different path to de-risking?
Q: WHAT CONSIDERATIONS SHOULD PLANS TAKE INTO ACCOUNT WHEN THEY’RE LOOKING TO REDUCE SURPLUS VOLATILITY?
A: Jeff Geller, Co-CIO — Because pension liabilities rise and fall with changes in long bond rates, many plans decide that buying long bonds is a simple step to de-risking their portfolio. While buying cash bonds should be an element of the strategy, it is not the only way to mitigate risk against liabilities. There are more creative methods to reduce surplus volatility while being cognizant of risks in the capital markets today.
Q: DE-RISKING PLANS STILL NEED GROWTH ASSETS. HOW DO YOU THINK ABOUT GROWTH AND HEDGE ASSETS TOGETHER IN A PORTFOLIO?
A: Jeff Geller — De-risking plans do, indeed, still need growth assets. Even a frozen plan has service costs and potential hits from mortality tables. While many plans think separately about their growth and hedge assets, we think about them in a holistic way—considering where we are in the cycle and what types of risk we should be taking.
Early in a plan’s life cycle, when the funded status is relatively low, a plan needs to take more risk and accept a wider range of outcomes. Later in the life cycle, when funded status has improved, a plan still needs to take risk, but it will be looking for a narrower range of outcomes (EXHIBIT 1).
One of the biggest contributors to risk in an LDI (liability driven investing) portfolio is equity risk, so a plan will look to diversify away from equity into asset classes that can deliver equity-like return with less risk, with a narrower range of outcomes.
Managing across the pension life cycle requires attentiveness to a sponsor’s risk tolerance
EXHIBIT 1: NORMAL DISTRIBUTIONS OF FUNDED STATUS OUTCOMES—FIVE YEARS
Source: J.P. Morgan Asset Management. For illustrative purposes only.
Q: WHAT DO PLANS SOMETIMES OVERLOOK WHEN THEY PROCEED TO DE-RISK?
A: Jeff Geller — Plans appropriately focus on the risk that comes out of equity. But they need to also focus on the risk that comes from credit. Perversely, this is exactly what plans are forced into purchasing as their funded status improves. As we move later in the corporate credit cycle, there is more risk in our liability hedges, and those hedges have gotten larger given funded status improvements. Since the financial crisis, investors have generally benefited from narrowing credit spreads. But later in the cycle, we become more exposed to widening credit spreads. Additionally, given the easy financial conditions that have prevailed since the financial crisis, as well as the pickup in M&A activity, the level of debt on corporate balance sheets has increased significantly. Even more concerning is that much of the increase in debt exists in the BBB space, which has grown to close to 50% of the investment grade universe from below 40% just five years ago. As long as earnings and growth keep pace, corporates should be able to service that debt. But we do see vulnerability in a scenario in which earnings are compromised amid a difficult economic environment and companies that are no longer able to service debt become candidates for credit downgrades. Given that many investors in these instruments have restrictions on holding below-investment grade bonds, forced selling could be the result of any downgrade cycle. Put another way, plans tend to focus on risks in their growth portfolio, but we’re thinking as well about embedded risk in the hedge portfolio.
Q: HOW DO YOU HELP PLANS MITIGATE THAT RISK?
A: Jeff Geller — One of the ways we have addressed this risk: We have been selling long credit and repurposing those investments into bank loans, which are further up the capital structure and have more defensive characteristics. We’re keeping the same level of hedge across the portfolio by buying back duration with treasury futures. Essentially, we’re creating a barbell strategy that allows us to sidestep some of the overly levered segments of the market. This allows us to create a liability hedge synthetically without buying instruments that we think are exposed to event risk.
Q: HOW DO YOU THINK ABOUT USING ALTERNATIVES IN PENSION PLAN PORTFOLIOS?
A: Jeff Geller — We have been leveraging alternative asset classes for our pension clients for years, quite successfully. The key for us is to be opportunistic and tailor the experience to each client’s individual situation. This is anything but a “one size fits all” type of approach, which we think can lead to considerable excess cost without a lot of benefit. In using alternatives, we look to balance the need for growth with the plan’s time horizon and ability to take liquidity risk. Earlier in a plan’s journey, when there is a significant need for asset growth, private equity can work well. We will make investments and judge them net of fees against what our clients can achieve by accessing the public markets. Private credit becomes more relevant when funded status improves, and the plan’s portfolio has likely become more conservative, with higher allocations to credit and treasuries. Of course, the environment has changed quite significantly for private markets in recent years—they’ve hardly been immune to the run-up in valuations that has occurred in the public space. We believe it is key to have partnerships with private managers to understand exit strategies and valuations, and evaluate how much risk is actually embedded in those investments. Given stable NAVs for these investments, it’s not always readily apparent what the next step will be in the life cycle. And because these investments come with significant liquidity risk, it is especially important to consider these factors when investing in private markets. Choose managers wisely and size stakes appropriately.
Q: TELL US HOW YOU THINK ABOUT BENCHMARKING. HOW SHOULD CLIENTS MEASURE YOUR SUCCESS?
A: Maddi Dessner — Clients are asking if, over time, we are delivering an improved outcome vs. their liability. And they’re looking at the path of returns to get there. Have we delivered an improved outcome but taken on big risk to get there?
Clients are also considering how much risk they are willing to take in terms of deviation from a public market benchmark that is a reasonable proxy to the plan’s liabilities. They’re thinking of a risk budget either in terms of surplus volatility, measuring drawdown risk in liabilities, or tracking risk against a public market benchmark like long government credit. Many clients are willing to see meaningful deviation from that benchmark. This is less about alpha tracking and more about delivering a better outcome while being mindful of the risk you’re taking. Our clients would be rightfully disappointed if we didn’t react to an improvement in their funded ratio by taking down surplus volatility in a significant way.