2018 Liability-Driven Investment Survey

Art by Chris Buzelli

2018: A Great Year for Funding and Pension Sponsors, Despite the Market Correction

Because of tax breaks and rising interest rates, 2018 has been a good year for liability driven investing and funding defined benefit plans. In fact, many borrowed to fund their plans to hedge next year’s rise in Pension Benefit Guaranty Corporation (PBGC) rates. Others sought to lock down gains from the nine-year bull market in the nick of time. Yet when de-risking, consultants warn that certain corporate bonds should be avoided.

Companies had until September to make their final contributions to plans at the higher 35% tax cut rate before it fell to 21%, and many did, according to Willis Towers Watson actuary and Senior Retirement Director Beth Ashmore. Although final figures won’t be tabulated until next year, numbers will likely show that funded levels hiked even further than they did last year, when they averaged around 85% funded for the top 100 plans. 
“It wouldn’t be surprising, based on year-to-date activity, to see an average [funded rate] rising into the low 90s. So, that’s a big difference,” said Ashmore.

The risk transfer activity to insurers continued to grow. Last year, there was $23 billion of overall obligations transferred to the insurers from the private defined benefit market place, and, according to the consulting and research firm Willis Towers Watson, all indications this year suggest the number is going to be higher.

October was a bumpier ride.  “The equity market had its correction, but we saw about another 25 basis point pick up in interest rates, so that kind of helped mute some of the effect on funded status,” said Ashmore.  
In November, Ashmore said, “We still think that the sponsors are looking at, at least right now, still a much rosier outlook for year-end ’18 than they were at year-end ’17.”

The drop in the stock market will likely not offset the benefits of the rise in interest rates.
Thomas Schatzman, institutional consulting director and a senior vice president, Morgan Stanley-Graystone, noted, “I’d say the damage is pretty minor in that regard because the present value of liabilities has been going down as rates have been going up.”

Now it’s the PBGC variable rate, which is hiking to 4.3% next year, that is causing people to aggressively borrow to fund their plans. Case in point: a $96 million plan that has $20 million in unfunded pension obligations, and $12 million which is exposed to a PBGC premium, incurs an $860,000 expense (on the $12 million) and it’s very hard to de-risk.  “You can still de-risk but you’re climbing an uphill battle because if your liability is growing at 4% and $12 million of your plan is subject to a PBGC variable rate of 4.3%: overall, that’s a liability that’s growing at 8.3%,” explained Schatzman. “We’re not going to hit 8.3 in anything. You could be invested 100% stocks, but we don’t think you’re going to have an 8.3 % rate of return in the next seven or 10 years.” If your cost of capital is 4% or even 5 %, then doing a debt-funded pension contribution might be worth getting out of the “hole.”

CIOs are also considering de-risking more as they watch the market’s nine-year bull run and consider whether it will run out of steam. “They’re really thinking about their cost of capital more than they have,” said Schatzman. 
Data this year are showing that if portfolios are fully funded, on a $100 million plan, it will take $5 million to $6 million more in today’s annuity market to potentially terminate the plan.

Something to be wary of is the portion of BBB bonds in a portfolio. At $2.5 trillion today, BBB bonds have grown 227% since 2009, according to Morgan Stanley corporate research.

“If we get into another credit cycle that turns nasty, during the past three recessions, we saw 30 percent of the BBB migrate down to junk,” said Schatzman. “We call them fallen angels. There were hundreds of fallen angels during the past three recessions.”
If they turn to junk, the damage could be “pretty bad” in terms of downside. Investors might not be able to hold them. Insurance companies won’t touch them. And investors will lose liquidity. The best play is to seek top-notch conservative credit analysts as money managers and eliminate the lower rung of BBB holdings immediately, said Schatzman.

“The worst thing ever would be you go ahead and borrow money, de-risk, and you end up with a bunch of bad corporate bonds in your portfolio,” said Schatzman. 
-Christine Giordano/CIO

Methodology:

The 2018 Liability-Driven Investing (LDI) Survey was conducted from mid-September through mid-October, and asked asset owners about their practices and views regarding funding, de-risking, and LDI strategies. Of all responses, 198 were identified as qualifying—i.e., by being from a senior investment official, with the authority and knowledge to answer LDI-related questions, at a qualified fund. For the sixth year running, the survey includes LDI vendor evaluations. Asset owners that indicated they use LDI were asked how they selected their provider(s) and also to rate those providers’ services in various categories. Nine vendors—BlackRock, Goldman Sachs, Jennison Associates, LGIMA, NISA, PIMCO, Prudential, Wellington, and Western Asset—received a sufficient number of client evaluations to be analyzed in detail. In addition, Capital Group, Conning, Fidelity, J.P. Morgan, and Loomis Sayles received enough responses to be mentioned but not enough to receive a written analysis. For more information, contact surveys@strategic-i.com.