This story begins at Verizon. The telecom giant—around the time it negotiated its $7.5 billion pension-risk transfer (PRT) deal in 2012—said liability-driven investing (LDI) wasn’t working for its pension anymore.
Its loss of faith in LDI was surprising, especially as Verizon had been a bold first mover in de-risking its corporate pension plan under the leadership of former CIO Ron Lataille. Two months prior to announcing its landmark PRT deal with Prudential—still the second largest in US history—Verizon outsourced its nearly $11 billion private equity and real estate portfolio to Goldman Sachs Asset Management. Shortly thereafter, 41,000 retirees had annuities from the insurer, not pensions from Verizon. So what caused this innovator’s doubt in de-risking, a strategy that has firmly taken hold with US corporate pension plan investments?
“Verizon’s LDI-oriented investment strategy meant getting rid of what it felt were good investments—like the hedge fund portfolio—to buy long-duration bonds, that are historically expensive, to lock in historically low yields,” says Ronan Cosgrave, managing director at Pacific Alternative Asset Management Company (PAAMCO), which counts Verizon as its oldest client. “So we sat down with them and said, ‘OK, let’s take the constraints of LDI and see what we can do with them.’ After spending months asking the simple questions like, ‘Why do we invest in bonds?’, it became clear that there was a need to invest in a more liability-aware manner, rather than a liability-matching one.”
In other words, the objective function of a pension plan transformed from managing liabilities to closing the funding gap—at least for Verizon and PAAMCO.
(Art by Cristian Turdera)
“The bottom line for both corporate plan sponsors and beneficiaries is the difference between assets and liabilities,” Cosgrave says. “‘Am I going to get paid all I’m due?’ ‘How much is this going to cost the company?’ This means the goal for plan sponsors should be to explicitly minimize any funding gap, or maximize a surplus. And it involves using assets other than long-duration bonds to diversify return opportunities.”
For plans nearing full funding, de-risking typically means replacing growth assets with safer ones to “lock in” gains and protect the funded status. LDI specifically uses assets with qualities such as liquidity and duration that are highly correlated to liabilities. The strategy has a strong support base: According to CIO’s 2014 LDI survey, 77% of all respondents have implemented LDI, while 19% had no plans to do so. The plan sponsors in question had an average 46% allocation to fixed income, of which 69% was long-duration bonds. An informal CIO survey also found 92% of asset owners and 95% of other industry experts saw LDI as a secular trend.
However, according to Cosgrave, simply matching liabilities with long-duration bonds is not enough to protect the funded status against “unhedgeable events.”
“The plan’s asset allocation should not be driven by the need to fund short-term cash outflows to the possible detriment of managing the funding gap in the long term,” he wrote in “Funding Gap-Driven Investing,” a recently released paper. “There are known uncertainties with regard to a plan’s ability to meet its pension obligations, despite what appears to be a current fully funded or overfunded status.” While long-duration bonds and liabilities may seem to match up, factors such as discount rates, credit risk, and inflation can substantially impact liability valuations. Furthermore, today’s historically low interest rates—and the anticipation of rising rates over the next few years—suggest now is an ideal time for narrowing funding gaps with asymmetrical hedging.
PAAMCO’s strategy involves swaption-based hedges, derivatives that protect funded status from falling interest rates. “Swaptions generally allow for the hedging of only gains, and not losses,” Cosgrave adds. “One downside is that, often with swaptions, you may trade away the ‘upside’ of rising rates, but you’re still not losing as much money as you would with cash bonds or traditional swaps.” Derivatives have become a fairly common hedging tool for de-risked portfolios: This year’s LDI survey found 63% of respondents using them, with 39% specifically relying on swaptions. However, Marty Jaugietis, head of LDI for Russell Investments, argues that derivatives are no panacea for the corporate pension market. Plan sponsors must first get comfy with the tactic before they can benefit from derivatives’ ability to “extend duration beyond physical bonds, customize exposure relative to the liability effectively, and even achieve ‘conditional’ interest rate exposures,” he says.
Beyond derivatives, PAAMCO’s approach also pushes to diversify risk premia with absolute return strategies. Thus, the theory goes, a fund can secure duration asymmetry without taking directional asset allocation risk. “In the context of seeking to structurally minimize the funding gap, relying on the single driver does not make sense as investors are basically widening the expected range of returns and, hence, the range of possible bad outcomes,” Cosgrave writes. Instead, he argues, diversifying with actively managed hedge fund exposures can also deliver alpha via “a highly uncorrelated source of return.”
PAAMCO and Cosgrave are not alone in pursuing a strategy that stands at odds with traditional de-risking. Private equity firm KKR’s hedge fund arm, KKR Prisma, released a similar study in June proposing absolute return programs in place of LDI to boost funding ratios and risk-adjusted returns. “While this LDI strategy yielded benefits in neutral market environments (when the probability of rates rising and falling was equal), and during periods of equity market instability (when a flight to quality favored bonds), we believe neither of these scenarios is consistent with current market conditions,” the firm wrote. It defined absolute return strategies as diversified hedge fund investments with low volatility, low equity beta, and marginal correlation to interest rate changes. KKR’s supporting arguments are parallel to PAAMCO: Hedge funds are risk diversifiers and return enhancers—two qualities not found in a long-duration bond portfolio.
“The most important factor for plan sponsors to consider when pursuing an investment in absolute return strategies is their investment objective,” says Eric Wolfe, managing director of hedge funds at KKR Prisma, “Do they want to keep the plan open or close it? What is the ideal funding level? How much volatility is acceptable?” Each plan sponsor has its own set of objectives, he points out. “If a plan is fully funded and wants to stop accepting new entrants, then asset-liability matching may be a sensible strategy.”
However, for open plans with a capacity to tolerate more risk, absolute return can answer the challenges of a rising rate environment, the firm states in its report. KKR generated three possible alterations to the traditional 60/40 portfolio with interest rates trending upwards by 50 basis points per year in the next few years: first a strategy with an LDI tilt (50% return-seeking, 50% fixed income), second with a 10% shift from the return-seeking portfolio to absolute return, and third with a 10% move from fixed income to absolute return. Through these simulations, the alternatives manager found the portfolio with the most aggressive tilt toward absolute return was most effective in improving funding ratios. (KKR’s calculations assume the return-seeking portfolio had lower returns and higher volatility than absolute return.) “Greater allocations to low beta absolute return strategies effectively reduce the sensitivity of the funding ratio to equity dislocations,” it stated. According to Wolfe, the current market environment offers “limited scenarios” in which LDI is beneficial. One example would be an even lower interest rate scenario in the US, where 10-year rates fall to 1% or less. He calls such a situation “possible, but improbable.”
But approach LDI alternatives with caution, says Joe Nankof, partner and co-founder of consulting firm Rocaton. “This is Risk Management 101. Plan sponsors need to keep in mind there is an amplification in their duration bet versus liabilities, equity market beta bet, and active management—or manager skill—bet if they move from long-duration liability hedging assets to absolute return. Their fees are also multiplied many times over.”
Even with a full understanding of all of these components of the strategy, Nankof argues that the value-add hedge funds deliver should pay their fees, something only the highly selective (or very lucky) allocator can achieve consistently. Vigilance is still necessary for such plan sponsors, he says, as the strategy runs the risk of over-diversifying skill and may incur unnecessarily high expenses. “This approach—to use absolute return in place of bonds—could be possible for open and growing pension plans that are looking to increase risk and have a portfolio that can withstand such risk associated with a funding gap that might worsen,” he adds. “More importantly, the potential financial burden of bets going wrong should not impair the company’s ability to run its business.”
Russell’s Jaugietis agrees with Nankof. Plan sponsors shouldn’t be quick to dismiss the merits of liability-hedging strategies, he warns. Interest rates are unpredictable, as could be seen by the unexpected drop of 50 basis points in the last few months. “Most market participants, again, have been reminded that in this environment, instruments that are specifically interest rate sensitive— such as fixed income and derivatives—are the ones that actually preserve funded status.” While Jaugietis doesn’t reject the idea of using hedge funds to improve funded status and minimize funding volatility, he says alternatives help only to a certain degree. “There are chances that returns from hedge funds—inclusive of any active management—may not be sufficient to match the growth in the liability and service accruals that are calculated in improving funded status.” In his view, PAAMCO and KKR’s strategies are unlikely to fit frozen and/or closed pension plans. With an even greater priority established for minimizing funded status volatility, as well as preserving its current level, these plans would most likely allocate the majority of their assets to bond or bond-like instruments in a true de-risking manner.
“We asked the simple questions, and we found the simple answers didn’t suffice,” PAAMCO’s Cosgrave says. “Investing in long-duration bonds is not well compensated; there isn’t enough risk premium. Only $2 trillion in investment-grade, long-duration bonds exist—not enough for all defined benefit plans. There needs to be diversification and asymmetrical hedging to take advantage of today’s low interest rates.” But both PAAMCO and KKR’s approaches raise the questions: Are unpredictable interest rates worth gambling on? Was Verizon onto something?