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Brian Pellegrino, CIO of one of the last open defined benefit funds in America, isn’t afraid to reiterate UPS’s decision to forego liability-driven investing (LDI): “We do not feel that LDI is an appropriate strategy at this time.” A bold move, as LDI has now infiltrated most corporate pension plans’ investment strategies to the extent that it’s almost second nature.
But Pellegrino may be smart to play the black sheep among a herd of corporate pensions. UPS is one of the healthiest funds above $20 billion. It boasts an almost 91% funding ratio with $27 billion in assets to its name, while liabilities total only 30% of the corporation’s market capitalization. Pellegrino and his team have high expectations—8.75% returns over a three- to five-year horizon—but they easily surpassed the estimate in 2011 with gains of 9.4% amid a flat market.
“Some characteristics drive us to build a materially different portfolio than most corporate plans,” the CIO explains. Rather than one specific strategy or another, Pellegrino bows to the need to allocate assets and construct a portfolio in the best interests of UPS and its employees.
The Atlanta-based courier service has the right—and rare—factors in place to excuse itself from liability matching, according to consultants and managers familiar with the terrain. “There’s only a minority of funds that can afford to do it,” says Scott McDermott, managing director of the global portfolio solutions group at Goldman Sachs Asset Management. Those plans that “are still open and have a financially strong corporate sponsor, for whom the plan liability is not material to the parent company’s financials, tend to be risk takers.”
So how did UPS acquire the ability to take more risks than other corporate pensions? The story begins with the parcel workers. A particularly young population of participants and fewer retirees put liability duration at somewhere between 17 and 18 years, with benefit payouts peaking after 2030. The firm also profits from a smaller annual benefit-payout ratio relative to assets than is typical, shelling out just a bit more than 3% compared with its peers’ average ratio of 9%.
“The long horizon allows us to gear more toward generating sufficient returns to meet future liabilities, rather than protecting assets to pay our current obligations,” Pellegrino says. “We’re somewhat uncertain of our future liabilities as our employees are still accruing benefits.”
UPS’s focus isn’t to put out fires, but to ensure the plan can weather all storms to deliver payouts on time, every time. Pellegrino is confident in the financials of his fund: They have enough capital to cushion and manage a potential hiccup, he contends. This is largely due to its promising obligations-to-market capitalization ratio. “Our unfunded liability relative to market cap is small. Since we moved to mark-to-market, we have become less concerned about short-term variability.”
Other corporate plans aren’t so stable or lucky. General Motors initiated a $26 billion pension-risk transfer deal with Prudential last year, surely due to its large liabilities compared with market capitalization and the potentially devastating impact of pension shortfalls on corporate financials.
“It’s a very individual decision,” says Joe Nankof, partner at Rocaton Investment Advisors, on whether or not to implement an LDI program. For some, “there are situations where it makes less sense to de-risk and more sense to continue to take risk for the purpose of generating returns.”
That’s exactly what UPS strives to do. Less concerned with matching liabilities to assets, UPS allocates far less to fixed income than other corporate plans—27% versus an average of 40%—and predominantly to long-duration treasury and corporate bonds. But return-seeking assets also have a place in the fund’s unconventional fixed-income portfolio, including high-yield bank loans, global bonds, and emerging market debt. With the space freed up by its modest bond holdings, UPS allocates an extra 6% to 8% to alternatives and public equities, with an overweight to US equity.
Pellegrino says the plan’s public equity portfolio is likewise not your average corporate pension stock bucket. “We believe the traditional market-cap benchmarks are flawed for various reasons, so we’ve created our own custom indexes that provide specific exposures, such as global consumer staples, managed or minimum volatility, and other risk-based metrics,” he says. “We’ve also added highly concentrated benchmark-agnostic managers who can focus on absolute, rather than relative, performance.”
The pension plan originally operated under a traditional investment structure—allocating assets, selecting managers, then assigning them a benchmark to outperform. It wasn’t until UPS was hit hard by the financial crisis that Pellegrino and his investment team thought to revamp the system. “2008 was extremely painful,” he admits. “We found that managers who invested aggressively or took excessive risk got hurt, and that had a huge impact on our portfolio.”
The revamping process began with building out the investment team. After some staff turnover in 2010, Pellegrino successfully grew his staff from three to 15, all focusing on a group trust structure under a single-employer Taft-Hartley plan. By now, the team has invested in secondary and co-investing opportunities in real estate and private equity, as well as liquid alternatives. “We’re looking for investments where we can understand what is driving returns, and with a runoff somewhere between three and seven years,” Pellegrino explains. “We are comfortable locking up assets for three to five years, especially if we know with some certainty what the outcome of that investment looks like.”
These strategies are paying off. According to company data, UPS had well exceeded 100% of its annual 8.75% return objective by the end of the third quarter of 2012, gaining more than $2.2 billion.
So what’s a CIO to do when he’s done more than he planned to do? “Once we cross the 100% threshold, we’re not as concerned about generating more [returns] as we are about protecting what we’ve earned for the year,” Pellegrino says. But funded status isn’t a priority for UPS, he continues. Governmental Accounting Standards Board statements put UPS past full funding, and mark-to-market accounting no longer considers shortfalls and adjustments based on pension performance in the operating profits and loss statements.
This kind of viewpoint provokes concern in some. “There’s a myth out there that if you’re a long-term investor, you can count on actually getting the high expected return assumption—but economists universally point out that this myth is not true,” says Barton Waring, an economist and the former CIO of investment strategy and policy at Barclays Global Investors. “It doesn’t matter how long your horizon is. You still need to hedge your liability in order to protect the safety of the plan’s benefits and to protect shareholders from large, unpleasant surprises.”
Others assert that abstaining from LDI may not be a reckless choice. “The decision to not pursue LDI doesn’t necessarily mean you’re [failing to] look at pension risk in a sophisticated risk-factor framework,” Rocaton’s Nankof says. “It’s about being deliberate about not matching assets and liabilities and taking that risk.”
Pellegrino understands this idea: “We realize that there will be years we do not achieve our goal of 8.75%. If you pay attention to the value of the assets and the investment opportunity in essence, you will capture the LDI or hedging component naturally.”
By the end of 2012, UPS’s hedging ratio was hovering above 20%—just enough to protect its assets and provide a level of flexibility and freedom to pursue riskier investments. “When you think of LDI, you think of portfolios’ hedge ratios and specific glide paths on when to increase those ratios,” Pellegrino says. “We give ourselves a tremendous amount of flexibility to move within asset classes and across the portfolio. We also put a lot of effort into evaluating the risk inherent in any investment, always focusing on finding the best risk-adjusted returns.”
If UPS continues to deliver investment returns as reliably as it does parcels, then flexibility isn’t a liability for Pellegrino and his team.