Interrogation: Harshal Chaudhari

Reflections on his first year, de-risking, and how IBM got to the enviable position of having a fully funded plan.

Art by Tim Bower

Art by Tim Bower

Harshal Chaudhari became IBM’s new CIO barely a year ago, in 2016, upon being tapped internally from his CFO post. It followed a gradual ladder climb, which he began as a senior consultant to IBM in 2002. The former software engineer and PwC consultant appears to come to the position with a multi-faceted understanding of both technology and investments.

IBM’s liability-driven investing (LDI) strategies are the major reason it is fully funded today. It began its LDI strategies in the 1990s, originally with a small part of its portfolio. Chaudhari inherited his position from Ray Kanner, who had taken the CIO post right before the financial crisis. Kanner quickly boosted the liability hedge and de-risked it further by reducing equities by 10 percentage points in the second part of 2007, which provided IBM’s pension fund with more shelter than most funds had during the crisis. Then, in the middle of the crisis, IBM almost completely increased the hedge, shielding the pension fund from the impact of the crashing rates.

When Chaudhari took over the $50 billion fund, it was 98.4% funded and fully hedged. When we last checked, it was up to 102%. He recently reviewed his first year with CIO.

CIO: How has your first year been? Have there been any developments, or changes to your plan? New asset allocations? New philosophies? New analytics?

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Chaudhari: The first year has gone by fast. I had a strong financial markets background coming into the role, but I had little familiarity with our external managers. So, I spent the initial months meeting and getting to know our managers. It was important for me to take the time to learn about the existing portfolio, understand the plan designs and the liability characteristics. I am fortunate to have a great team, and there is a lot of historical data and documentation, which made it easy to get up to speed quickly.

Since then, we have taken a number of actions on the portfolio. We executed another de-risk earlier this year as strong markets continued to improve the funded status of the plan. I have initiated an effort to redesign our absolute return portfolio with a view towards better diversification. We have also been busy on the manager search front with roughly half a dozen new mandates. We also undertook a broad portfolio review of our worldwide plans last year that resulted in significant asset allocation actions for several international plans. On the systems side, we are in the process of deploying a new set of analytical tools, including a multi-asset risk system.

CIO: Your plan has been described as a “de-risking machine.” What was put in place over time to make it fully funded?

Chaudhari: To quote Peter Bernstein, “risk is a choice, not fate.” As a mature plan with a relatively stable liability profile, our asset allocation strategy is naturally driven by a liability-aware approach. This philosophy has existed for a long time. When we were underfunded, the focus was on closing the funding gap. Now that we are fully funded, the focus has naturally shifted to preserving and growing the funded status. Aligned with that strategy, we have undertaken a methodical approach to shift our asset allocation over the years to gradually reduce the equity risk and increase the hedge ratio. We have taken three actions in the past four years as the funded status has continued to improve. We also have a laser-like focus in ensuring our active program is risk-controlled and delivers a high-quality alpha stream.

CIO: You had a trajectory plan, where you took only the amount of risk you needed to take (hedging, etc.) to protect your downside and accumulate and lock down gains. Can you go into detail on it?

Chaudhari: We prefer a thoughtful dialog before we make meaningful changes than having a formal trajectory plan, which is often simplified and mechanical. We have a very good sense of where we are going, though, and our governance and operational processes are very strong. This allows us to act swiftly and deliberately to alter our asset allocation as opportunities arise.

CIO: Now that your plan is 102% fully funded (congrats!), what level of risk taking is the right level for you?

Chaudhari: We are in a good position and would like to build up a more comfortable cushion. However, we can be patient and do not need to chase returns. The risk has been reduced by roughly a third since the beginning of last year, and our return expectations going forward are modest, but sufficient to grow surplus at a measured pace. The lower risk profile is intended to withstand substantial market drawdowns.

CIO: If the risk taking is a lot less, the asset liability risk management is more important. How are you structuring and hedging your liability risk so there’s not a lot of drawdown in the future?

Chaudhari: Spending time in IBM’s treasury department has ingrained in me a deep risk management perspective. Coincidentally, one of my jobs there was to analyze and mitigate asset liability risk, focused on managing net interest margin of IBM’s financing business. That experience extends naturally to a liability-driven investment approach. As we have de-risked, we have moved a quarter of our portfolio into fixed-income in the past year and half. This has enabled us to focus on fine-tuning the hedging portfolio. We have reduced the reliance on derivatives, and STRIPS have become a key ingredient in our toolkit. Yield curve match has been improved, and we have been focused on improving the macro factor balance to increase the resiliency to shocks from changing economic regimes.

CIO: This is truly an open-ended question, not necessarily about LDI. As an investor, what do you find exciting or innovative?

Chaudhari: One of the exciting aspects for me is the constant learning. As an allocator, one needs to develop a tremendous amount of breadth and it is incredibly intellectually stimulating. This industry attracts a lot of smart, opinionated people that have strong viewpoints—active vs. passive, fundamental vs. quantitative, rational vs. behavioral are all riveting topics. I view the truth as usually somewhere in the middle, but it is fascinating to get a glimpse into how different people think and the variety of investment approaches. Cryptocurrencies is one of those topics that brings out some very strong reactions from both sides. It is still too volatile as an investment vehicle, but I am paying attention to this area as I believe the blockchain technology promises to be a game-changing innovation for investing, for finance, and for applications much broader than that. While all of this is very exciting, as an investor, staying grounded and translating the exhilaration of the markets into a portfolio that delivers steady, consistent returns is an exciting challenge, in my view. —CIO

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Interrogation: Brian Pellegrino

What he’s considering after announcing a plan freeze and making a $2.3 billion contribution as UPS explores LDI.

Art by Tim Bower

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.

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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

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