Art by Tim Bower
CIO: When you funded the plan with $1.25 billion this year, with plans to borrow $1 billion to do it, were you doing it because the PBGC plans to raise its rates over the next two years?
Hunkeler: That was an important part of the equation, but I think it was bigger than that. We look at our pension plan as part of our overall debt structure, so one of the things we were trying to answer at the company level was where we wanted to be from a total debt perspective. We also considered the higher tax deduction benefits that would be available, should tax reform actually produce some fruits, making it better to take those deductions this year, rather than in the future. Finally, this was all part of a larger plan to right-size our pension liability relative to the size of the company.
CIO: Can you go into detail on that? How do you determine the right size of your pension liability?
Hunkeler: Well, you compare yourself to other companies in your industry, or just to other companies in general. Our pension liability was quite large relative to the size of the company. The market value of the company was around the $20 billion range, and our liabilities were around $14 billion.
CIO: How did your funded value change after the infusion?
Hunkeler: At the end of last year, we were 77.5% funded on a PBO basis. The $1.25 billion contribution we made in August raised our funded status considerably. Plus, we’ve enjoyed good investment results so far this year. That combination has lifted our funded status significantly.
CIO: Over 80%?
Hunkeler: Yes.
CIO: Was that the goal?
Hunkeler: I wouldn’t say that, in and of itself, was the goal. Our goal was, and is, to make sure that, ultimately, we’re keeping the plan in a position where it can pay out all benefits when they come due. We have a long record of contributing voluntarily to our plan to maintain a sound pension structure. This latest contribution will essentially remove the requirement to fund the plan for the next five years.
CIO: Did you have concerns about interest rates in the future?
Hunkeler: Always. That is a constant concern, whenever you’re doing an LDI strategy, you’re always going to be afraid that you’re putting on a hedge at just the wrong time. There’s really no getting around that fear. You can only manage it, you can’t avoid it.
CIO: What opportunities did LDI present to you specifically?
Hunkeler: The biggest benefit is in managing downside risk when interest rates decline. When we looked at our forecasts of how bad contribution requirements could be—for example, in a rapidly declining interest rate environment with poor market performance—we saw that it could get to a level where it might impact the company’s ability to fulfill its strategic objectives. So, in short, I’d say the biggest benefit of LDI is being able to ring-fence our pension fund’s downside risk.
CIO: Can you offer advice on how you determine the hedging levels and the triggers that you consider?
Hunkeler: First, let me say that we were early to the game, before we were late, but I’ll get back to that later. We started dipping our toe into the LDI waters back in 2002. At that time, we used derivatives to extend the duration of our bond portfolio. Then, in 2006, we decided to expand that strategy to the entire plan, by putting in place what today would be considered a real glide path. The plan back in 2006 was to gradually increase our interest rate hedge relative to our liability to 50%. We planned to use a combination of rate and date triggers to get us to the desired level by the end of 2008. At that time, we also determined that a 75% hedge would probably be the right long-term ending point for a number of reasons that maybe are no longer applicable. We didn’t dwell too much on the endpoint, because we said, ‘Look, you’ve got to get to 50% to get to 75%, so let’s just get started, and we’ll fine tune our planning when we get to that point where fine tuning makes more sense.’
So, my advice here would be not to get too hung up on the end point, just get started. Think about it like a moonshot. Just launch the rocket and worry about steering it to the moon when you get a little bit closer.
CIO: How did you use date triggers?
Hunkeler: In our original LDI plan, we wanted to get to 50% by the end of 2008. When we started in 2006, we assumed that interest rates would be rising over the foreseeable future, and if they did, it would benefit us to get there gradually. But we also decided if, by the end of each year, rates had not reached certain target levels, then we would go to our next hedge ratio regardless. So, it was either the rate trigger, or the date trigger. Whichever one we crossed first would be determinate of when we would go to the next hedge level.
Originally, our hedging was done entirely with swaps as an overlay to our underlying asset portfolio. Then, in 2008, during the financial crisis, swap rates decoupled from corporate bond rates, which led to this very weird situation where our swaps were making lots of money, while the spread on corporate bonds was widening out.
We were concerned that when swaps and corporates eventually recoupled, we would lose all the money we had made on our swaps’ position. So, at the end of 2008, we decided to turn off the swaps overlay program.
The problem was, we didn’t find a good reentry point for many years after that. It wasn’t until 2016 that we actually reentered the LDI glide path business, and now, we’re probably somewhere in the middle of where other large corporate plans are that are doing LDI. That’s what I mean when I say we were early before we were late.
CIO: How are you doing things differently, now that you’ve reentered?
Hunkeler: We have introduced date triggers again. Between 2008 and the present, we reintroduced an LDI glide path, but we did it without the date triggers. Instead, we used a combination of funded status and interest rate triggers. The problem was, we never hit those triggers.
CIO: What would be your advice to those who worry that interest rates will rise?
You’re always going to be worried that you’re at some sort of bottom where rates are just about ready to go up. Take it from me, I’m a recovering interest rate predictor.
I guess my message is this, ‘If you’re inclined to try to outsmart the market on where rates are going, don’t.’ It’s much more important that you have a plan of where you want to go, and then come up with a reasonable glide path to get there. Using interest rate or funded status triggers is probably the most logical way to go, but you should also realize you may not hit those triggers for a long, long time.
Adding date triggers to your glide path is one way to get around that problem, but it also makes the journey more uncomfortable. That’s because if you implement it religiously, then more likely than not, you’re going to feel really bad when you hit one of those date triggers. But you have to stay disciplined. If the fear of rising rates is too great, then just slow down the rate of increase, but don’t turn it off.
CIO: Do you have any thoughts on bonds when rates are so low?
Hunkeler: Avoid them. [He laughs.] I would say there are hardly any asset classes out there that look particularly attractive. I think you have to reset your sights on lower-than-normal expected returns in general. Within that framework, is there any one asset class that looks particularly better or particularly worse than any other? Not really. They all look equally bad. So, we’re not titling our asset allocation much in favor of any one particular asset class, with the exception of perhaps non-US equities, where we favor them over US equities. Other than that, I couldn’t tell you that any asset class out there is screaming, ‘Buy!’ especially bonds.
CIO: Are you fully hedged?
Hunkeler: No, we’re not fully hedged, and I don’t think we would ever be fully hedged. Again, a lot of this has to do with our forecasting and what we’re willing to tolerate in terms of downside risk. From a philosophical standpoint, there are only three ways we can fill our funding gap: We can earn our way out of it through better asset returns, we can contribute our way out of it by putting money into the plan, or we can wait for interest rates to rise. At IP, we’re using a ‘three shovels’ approach. We aren’t going to rely on any one shovel to solve our problem. We’re going to use all three. One of the ways we’re doing this in our LDI program is by making extensive use of derivatives to get to the hedging ratios we want to have. This enables us to maintain a more growth-oriented asset portfolio while still controlling our interest rate risk.
I’m actually somewhat surprised that more plan sponsors aren’t using derivatives to a greater degree to manage their interest rate risk.
CIO: What advantage does it give you?
Hunkeler: The really great advantage is it enables you to maintain a more growth-oriented asset portfolio, while still hedging the interest rate risk through derivatives.
CIO: This year, you decided to make a voluntary pension contribution of $1.25 billion to be partially funded through a $1 billion debt offering. How did you decide on the $1.25 billion amount?
Hunkeler: Yeah, part of that had to do with what we call the ‘regret factor.’ When we did our pension contribution forecast with our consultants at Rocaton, one of the things we focused on was, ‘What’s the probability of having to make a contribution of at least that amount over the next five and 10 years?’ So, we looked for a number where the probability of having regret—of having put money into the plan and then later realizing we didn’t need to put that much money in—was quite low.
CIO: Did you have any challenges with borrowing to fund the plan?
Hunkeler: No, not really. That was handled by our treasurer, Errol Harris, and was well-communicated to the marketplace about what we were intending to do with the money. I think investors and the rating agencies were well aware of what IP was trying to do with its pension plan, and saw it as a logical step.
CIO: How were you using Rocaton?
Hunkeler: We have them on a retainer consulting relationship, so they help us in just about everything we do, including asset allocation studies, LDI, manager searches, performance evaluation, etc. We view them as an extension of our internal staff.
When it comes to manager searches, we’ll work with Rocaton to identify managers who are best-in-class, and then whittle their list down to three or four before we do interviews in-house. NISA handles our derivatives exposures for us. We’ve been shifting some of our physical assets from shorter duration bonds to long bond portfolios, so we have specialist managers working there as well.
CIO: Is there something you’ve learned during the process that people might overlook? Anything that CIOs should be especially aware of?
Hunkeler: First of all: The temptation to bet on rates is huge. Don’t. The second thing is: Don’t own this decision by yourself. This is a corporate-level decision that needs to be made with, if not explicitly by, senior management. And certainly, with their direct input. Back before 2006, when we were talking about going through an LDI strategy, it seemed like a very scary decision, because we were talking about literally billions of dollars of interest rate exposure. We knew then that this was a decision that the company had to own, not just the investment office. So, that would be my second bit of advice: get everyone involved.
Third, don’t be afraid to use derivatives to help hedge your interest rate risk. This allows you to maintain a more aggressive asset portfolio while still managing the interest rate risk. And finally, the key to managing pension risk is developing a glide path, and then sticking with it. Try not to fall off the path. —CIO
Tags: Bob Hunkeler, CIO, International Paper, LDI