September 17, 2019

Hooray, LDI Is Progressively Making Corporate Pension Portfolios Less Risky

Fixed income now is their largest asset class, but this comes with a caveat. Sliding interest rates might thwart further improvements.

Reported by Larry Light

Art by John Cuneo

Liability-driven investing has made great strides toward its goal of lowering the risk for corporate defined benefit plans.

With the advent of under-funded pension programs, LDI has emerged as the most widely used antidote. The idea is that, by de-risking portfolios, plan managers can prevent any further erosion of their assets’ value and at the same time inch back to the fully funded level (their ability to match obligations to participants). And it looks as if many are pulling off this neat trick. LDI typically tilts portfolios toward asset classes that are perceived to be “safer”—like bonds, and away from stocks..

Last year, fixed income composed 43% of plan assets, compared to 30% for stocks. In 2014, the two asset classes were even, with 39% each. The rest of the pie goes to alternatives, ranging from private equity to commodities to real estate. This area has risen to 27% from 22% in four years, according to Conning’s Annual Corporate Pension Review. As of July, 88% of S&P 500 company plans used LDI, concludes a survey by Goldman Sachs Asset Management.

And here’s some more good news: plans’ funded level has improved. In 2019’s first half, companies adopting LDI boosted funded status by 2.1%, while those depending on more traditional methods had a 0.3% decline, according to a study by asset manager Insight Investment, the world’s largest LDI manager.

While company plans don’t employ LDI for their entire portfolio, the amount covered stood at an average 49% last year, CIO’s LDI poll shows. Often, plans will hire outside managers to oversee LDI solutions.

But there may be some trouble ahead. The Federal Reserve is expected to lower interest rates further on Wednesday, which will make life tougher for pension plans. Lower interest rates make it harder for bond portfolios to provide the boost to funded status pension plans need.

As a result, funded status is suffering somewhat of late. In April, funded status stood at 91%. Goldman expects that level to dip further to 86%, losing two percentage points, when the August results are tabulated. And that could lead to companies having to contribute more to their plans, something they would rather not do, preferring to put the burden on investment returns to escalate funded status.

LDI is designed to help pension plans avoid making higher contributions by creating a “glide path” that aims to gradually diminish risks while also earning a return that equals or exceeds the increase in projected pension plan liabilities as more employees retire.

LDI Offers Plan Sponsors A Life Raft

The focus on matching liabilities to obligations, which seems like an obvious thing to do, wasn’t on anyone’s radar until this century, in part because pension funding was relatively stable until recently.

“In the 1990s, no one thought of liabilities, since plans were overfunded,” recalled Robert Hunkeler, chief investment officer of International Paper. “Then came two recessions that knocked the plans back.” International Paper has responded to the challenge by, among other steps, moving up fixed-income exposure to 51% from 30%.

Back in the good old days, the living was indeed lush for company plans. Corporate DB programs surged in the 20^th century, with their assets growing even though many companies started emphasizing 401(k)s.

From 1976 to 1999, DB assets exploded, up more than tenfold, US Labor Department stats indicate. With the dot-com bust and its attendant recession, they lost some 20% through 2002. That set the stage for LDI.

Pension assets recovered after this wipeout, and took part in the buoyant growth of equities that accompanied the housing boom. The asset base expanded 50%, to $2.5 trillion in 2007. Then the bottom dropped out. With the financial crisis, assets shrank to $2 trillion. Since then, assets have recovered, but with more and more benefits claimed by the swelling horde of retirees, that hasn’t been enough.

The Pension Protection Act of 2006 put more pressure on pensions to adopt LDI.. The measure required that corporate pension liabilities be discounted at currently prevailing interest rates. This meant that companies had to mark-to-market their pension investments and net funded status.

Another headache for DB programs,was the hike in Pension Benefit Guaranty Corporation (PBGC) rates, which ate into capital reserves. The PBGC, a government entity that insures DB plans and covers participants if the employer goes bust, has been in the red and to fix that the agency has steadily increased it rates. In 2016, the rate was $34 per $1,000 of a plan’s unfunded vested benefits. This year, the rate has risen to $42, a 23% bump.

The Many Roads to LDI

Investing is a protean world. Not long ago, higher interest rates, at least in the US, seemed assured. Then suddenly, the ground shifted, as the Fed once again lopped rates. Europe and Japan offer negative rates, where banks charge for deposits, instead of paying interest. President Donald Trump has urged the Fed to follow suit. Meanwhile, no one knows how long the stock bull market will continue.

Many LDI strategies utilize hedging methods to protect portfolios against rate changes and inflation. For a long time, bonds were at the vanguard of this effort. Nowadays, plans often turn to swaps and other derivatives as a bulwark against problems. Some 71% of plans use derivatives, the most recent CIO survey discovered.

Companies are also implementing other methods to offload their obligations, such as transferring them to insurers. Recently, Lockheed Martin shifted $2.6 billion in pension liabilities to Prudential and Athene. But such tactics don’t come cheap, and they entail some outlays from corporations. Employers first need to ensure their plans are fully funded—insurance providers don’t want to be saddled with an underfunded pension program. “They have to pay up to get to 100%,” said Jeff Whitehead, head of client investment solutions at Aegon Asset Management. Insurers don’t want to acquire all of a company’s pension obligations, he added, and perhaps might take just current retirees, not plan participants still working.

Overall, corporate CIOs are pleased with LDI. Consider United Technologies, a conglomerate that makes everything from aircraft engines to elevators. “The LDI program has done fantastic,” said CIO Robin Diamonte. The company, which took on added liabilities with the acquisitions of Rockwell Collins and Goodrich, has moved from underfunded status to 100% funded as of July.

“We did it in small steps,” Diamonte said. The company, which is eyeing splitting into three new businesses, started by closing the plan to new participants, diversifying the portfolio, and creating a sophisticated LDI program, with fixed income now 54% and a 66% hedged ratio. “We created an LDI report card to see where we had mismatches, identify mismatches, and understand sensitivities,” she noted. “I’d rather have UTC’s investment analysts talking about our jet engines, not our pension plan.”

With good planning and good luck, more and more corporate pensions can tout similar results in coming years.