DIY Annuities Are Here

Over the past five years, plan sponsors have started to look for greater customization in LDI strategies. Private debt could be an option for plans that still have funding goals to hit or want to retain control of their plan assets.

The past two years have been great for pension plans that needed to improve their funded statuses. Accommodative market conditions have helped plan sponsors achieve return targets. A recent spike in Pension Benefit Guaranty Corporation (PBGC) premiums has also accelerated contributions to plans in order for institutional investors to avoid paying insurance fees.

While all of this may look good on paper, allocators have also started to take a closer look at risk. Accelerated contributions can heighten concerns around trapped assets if circumstances in a plan change. For portfolios that may be optimized to the current low-volatility, high-return market in the US, the possibility of a coming market correction and its attendant volatility is cause for concern.

With the options for de-risking a pension plan becoming well known, updates to the plan design are one way to go. Partial risk-transfer payments have become popular over the years, as have full buyout annuitizations. However, each of these options come with drawbacks. Major plan changes and annuitizations can be high-cost maneuvers that often require a significant management effort. Working with insurers to set up annuitizations also involves making sure the plan has the right asset mix already in place. Traditional risk transfers are also problematic if a plan isn’t fully funded or only recently achieved a funding status that would make risk transfer possible. For allocators that want to make a change but aren’t ready to execute a full risk-transfer, Toronto-based TD Asset Management (TDAM) is making the argument for a middle way—a DIY annuitization of sorts, using private debt. The option has been available for just over a year in Canada and could be a framework for allocators going forward.

The idea behind the pooled trusts is to provide an annuity-like risk/return profile without surrendering control over plan assets the way an annuitization does.

“With the structure we offer, we are putting together a mix of strategic investment-grade private debt assets—examples include P3s [public-private partnerships] and long-duration corporate credit—highly structured products that we have a visibility on our internal rating all the way to the maturity of the transaction,” explains Louis Belanger, portfolio manager in the private debt group at TDAM. The firm has two such pooled trusts—a private debt pooled fund trust and long private debt pooled fund trust.

The asset mix within the trusts is approximately 50% private debt, which is used to harvest long-term illiquidity premiums; 30% public corporate debt and 20% government bonds and STRIPS, which can be used to rebalance liquidity. “There are longer lockups with investment-grade private debt, so allocators want to think of this as a strategic, not tactical, opportunity, which can mean thinking about private debt in a total portfolio context,” notes Michael Augustine, managing director at TDAM. Augustine adds that it is important to separate out the types of securities in a pooled trust from the typical eight-year lockup, return-generating private debt strategies that people are likely to think of when they hear private debt.

According to Belanger and Augustine, the idea for the structure came out of conversations with allocators that were looking for a bit more customization without necessarily having to get into a complex arrangement with insurers. They contend that with the strategy, plan sponsors can forego the multi-million dollar opportunity cost of setting up an annuity deal. Belanger adds that by maintaining a portfolio of long-duration private debt assets, plan sponsors will also be able to post collateral and implement custom portfolio overlays that allows for allocators to self-determine a risk/return profile for specific plan populations.

With private debt investments as collateral, plans could add an equity overlay, for example, where gains from the equities market are periodically harvested and invested into the private debt portfolio. In a bull market, this type of an overlay gives allocators the ability to participate in the rally and fortify long-term liabilities at the same time. Strategies that allow plan sponsors to shore up funding levels and manage liabilities have grown in popularity in recent years as more plans try to move from 80% to 100% funded. Allocators should be clear, however, long-duration private debt is an actively managed approach to de-risking that will require monitoring throughout the lifetime of the total portfolio, versus an annuitization which requires most of the effort up front, when setting up the risk transfer.

“One of the benefits to using private debt is that investors can minimize ‘regret risk’ versus purchasing an annuity, in the sense that they haven’t given up every lever of control that they have over plan assets,” Belanger says.

There is also an exit strategy if conditions change. The pooled trust structure allows plans a way out if they opt to move to a termination or if unforeseen circumstances arise. “That is why the fund isn't structured as a closed-end fund,” Belanger explains. “We would seek to match demand in terms of the same numbers exiting the pool that want to enter it at any given time. So, from that standpoint, the pool remains pretty stable.”

Still, while sources CIO spoke to say there is an appetite for more customization, few were willing to view private debt as anything other than a medium-term return-generating asset class.

David Kelly, chief investment officer for North America at Aon Hewitt, says that private debt “can be part of glide path de-risking if you manage around some of the issues like liquidity.” For Kelly, concerns around price sensitivity and price matching liabilities makes even long-duration private debt a tough sell.

As a total return strategy, Kelly notes, investors could consider an allocation to private debt as a return-generating diversifier alongside more traditional investment-grade fixed-income.

“You want to be clear about what’s in the portfolio, what the risks are,” Kelly says, adding that this late in a credit cycle, the future may not look anything like the recent past in terms of returns and investment quality. Manager selection is also critical, Kelly notes.

Greg Garrett, fixed-income investment specialist at Los Angeles-based, $1.4 trillion Capital Group, agrees. He adds that when setting up any private debt investment strategy, it is important to make sure that you are working with trusted investment managers that have a track record of management in a variety of market conditions. Plan sponsors will also want to consider duration risk. Like Aon, Capital Group views private debt as part of a return-generating strategy and would work with outside managers if an investor wanted to include private debt as part of its overall credit portfolio.

Art by Jenice Kim

TDAM's trusts typically consider a 30-year credit rating when they are looking at securities for the pool. TDAM's Augustine adds that for plans that have been working to improve their funded statuses, having the opportunity to harvest gains either through an overlay or realizing incremental yield within the private debt portfolio can be important.

“What we are seeing is that more fully funded plans are trying to avoid sliding backward, and so you want to have an appropriate mix of return-seeking and liability-hedging investments to achieve that goal,” he contends.

John Delaney, a Philadelphia-based investment consultant with Willis Towers Watson, acknowledges that sponsors are looking at a wider variety of options for their portfolios to avoid going backward, but still advocates for caution. He says that interest in private debt is largely coming from his corporate defined benefit clients and while he has made allocations, just because a strategy is in the headlines, it doesn’t always mean that it’s time to jump in with both feet. “There’s a lot of cash flow into the space right now, which can give you pause if you are looking for strategies that are less correlated,” he says. “Sponsors have to make sure that a strategy is actually differentiating.”