Art by Tim Bower
In 2017, UPS announced it would freeze benefits to 70,000 non-union active employees in the management defined benefit plan by 2023. Its other non-union and union plans will remain open, so the change won’t affect its 340,000 union and non-US employees, worldwide, but the fund was $7 billion short of the $25.3 billion it needs to fund non-union benefits.
In February, UPS made a combined
$2.3 billion contribution to both its nonunion and union pension plans. CIO Brian Pellegrino, known for delivering strong alpha and meeting his 8.75% annual expected return targets for more than six years, is now exploring ways to apply LDI strategies.
CIO: As you’re heading into LDI discussions or considerations, what’s on your mind?
Pellegrino: The announcement to freeze our retirement plan, which is primarily for non-union employees, will definitely result in some modification to our investment strategy for that plan. We have always considered ourselves liability-aware rather than liability-driven investors, but we are now considering strategies that would move us closer to LDI. Since we have a five-year window before this plan actually freezes, we can be diligent in evaluating different options before settling on the strategies that will eventually be implemented. At this point, we are not looking at anything that is outside of what would be considered traditional or normal in the LDI space.
CIO: What does that mean in terms of strategy?
Pellegrino: We will most likely end up with a strategy that resembles a glide path, either time-sensitive or event-driven. I would think that it would be more likely to be event-driven, allowing the portfolio to increase the liability-hedging assets as rates increase and/or our funded status improves. We will still need a certain percentage of the assets to continue to be return-seeking in nature. It is still important to generate investment income to contribute to the reduction of the funding gap for this plan.
CIO: What are your biggest challenges and considerations so far?
Pellegrino: Since we have a shortfall in all three plans—the plan which is closing, as well as our two non-union plans that remain open—we need to identify the appropriate strategy that allows us to better hedge our liability streams as they become more certain, but also maintains enough return-seeking assets to generate sufficient returns to help offset the near-term growth of the liability.
Today, we manage the assets for all three plans in a master trust structure, but once the retirement plan becomes completely frozen, we should end up with a different strategy for each plan. The non-union plan will potentially move quicker towards de-risking or LDI strategies. Since two of the three plans will remain open and the third has a five-year window, we still need to be concerned about our ability to generate adequate returns, especially over the near-term, to help reduce our funding gap and offset service costs.
CIO: You’re just starting to consider LDI, or are you well into discussions of it?
Pellegrino: We have been addressing our pension obligations for the retirement (non-union) plan since 2008, implementing changes such as the transition to a cash balance structure, offering term-vested payouts, closing the plan to new entrants, discretionary funding when it makes sense, and now announcing the plan will be frozen in 2023. LDI has always been part of the discussion. It is the freezing of the plan that has made this a priority for the near future.
CIO: What’s your method of choosing your LDI strategist, and what do you find has worked for you when choosing managers in the past?
Pellegrino: We currently have strategic partners in the space who will help us in identifying and implementing the right strategies. These relationships were established over the last four to five years with the goal of having them in place when we would be in a position to move forward with LDI. Because we have what we believe are the right relationships, our LDI strategy will most likely be implemented by our existing managers. We also have a short list of potential new managers that can be added if needed. Since there is a possibility the fixed-income allocation will increase significantly over the next three to five years, it may be necessary to expand that list, but we are not ready to do that at this time.
CIO: Is there any particular area of expertise you’re looking for?
Pellegrino: Although our core fixed- income portfolio includes both US Treasuries and Long Corporate Bonds, we actually treat them as separate portfolios. So, even if a manager is given dual mandate, they manage each piece separately. Once we identify the appropriate strategy going forward and determine the timing of its implementation, we can then revisit our manager line up and decide where we need to add capacity. Until then, we won’t know what specific expertise is needed.
CIO: You’re known for delivering alpha. What are you watching now?
Pellegrino: Since 2012, almost half of the money we’ve put to work in private equity, credit, and real estate has been in custom or bespoke mandates. This gives us better visibility into the underwriting process as well as more control of the economics. These strategies have worked well, but in today’s environment, they are much harder to find.
We have done something similar with our global equity allocation and currently have almost half of that portfolio in custom beta strategies. Since 2010, the custom beta strategies have provided significant value-add to the overall portfolio. Our strategy for the remainder of the portfolio is prioritizing liquidity, and we continue to manage our hedging and risk programs.
We are always looking for new opportunities, so I can’t identify one specific thing that we are watching. The most important thing for our team is to be in a position to react quickly when opportunities present themselves.
CIO: Are there any opportunities that you’re specifically watching for when it comes to liability-driven investing or de-risking investments?
Pellegrino: From an asset perspective, it’s the timing of deploying additional assets, and the current level of rates has a lot to do with that. From a balance sheet perspective, it is more about funded status and timing of contributions. So, as rates rise and/or funded status improves, we would expect to start increasing our allocation to LDI strategies. Although LDI strategies are great for preserving funded status, there is the risk of incurring losses if interest rates rise. Any strategies that help preserve capital in that environment may be worth exploring.
CIO: What were some of the considerations in determining the five-year window to freeze the plan?
Pellegrino: The primary reason was to enable affected employees to plan for the change as they consider their retirement needs. Another important objective was to minimize the number of significantly affected employees, and a third goal would be to remain competitive in the marketplace. The company is committed to offering above-market benefits to attract and retain talented employees.
CIO: Are there any chief investment officers you’re particularly looking to, who did it right with their LDI strategies?
Pellegrino: As a working group member of CEIBA, we have access to many of the top CIOs in the Corporate DB space. Although I try to learn from all of them, quite a few are much further along in their LDI journey. I have already started and will continue to tap into their expertise as we formulate a strategy and move forward with our LDI implementation. —CIO
Tags: Brian Pellegrino, CIO, Interrogation, LDI, UPS