2020 Liability-Driven Investment Survey | Chief Investment Officer

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2020 LDI Still Seeking Less Risky Fixed Income

Despite dismal rates, DB plans still choose to de-risk with bonds.

Liability-driven investing, or LDI, has had a profound effect on the makeup of companies’ pension programs. The asset mix for corporate plans has grown steadily more conservative over time.

In 2005, before the global financial crisis slammed stocks, the equity allocation was 60%, with 30% in fixed income, Milliman stats show. By 2019, that had switched: equities had fallen to 32.5% and fixed income had risen to 49.1%.

Funded status for corporate plans has slipped this year, according to global investment manager Conning. In October, it came in at 83%, down from 87%, year-end 2019. Some of that likely stems from market turbulence, not the least of is the rock-bottom interest rates that have made fixed income generate lower returns.

The core of the dilemma is what’s called “negative convexity.” The more rates fall, the faster liabilities tend to increase. As LDI manager Insight Investment stated in a recent report, a 30-year AA-rated corporate bond, for instance, has seen its yield drop almost a full percentage point this year. Among the 100 largest US corporate defined benefit (DB) plans, liabilities are up 11% and assets down 3%, the firm calculated.

There has been a reluctance of late to go more into fixed income, said Shivin Kwatra, head of LDI portfolio management at Insight. “Plans have been under-hedged,” as a result, he said. A few months ago, he pointed out, the benchmark 10-year Treasury note was yielding just under 0.5%, quite a fall from the almost 1.9% it sported at the start of the year. (Now it is around 0.9%.)

Nevertheless, shifting to bonds from stocks has the virtue of “giving you more certainty,” said Amy Trainor, LDI team leader at Wellington Management, because bonds mimic the movement in the plan’s liability and can lead to more stable funded ratios.

All of which supports the case for continued use of LDI. Use of, say, long-duration corporate and Treasury strips offers diversification, as well as higher coupons, reasoned Kwatra. What’s more, a report by Wellington indicated several areas in stocks that are ripe for portfolio enhancement.

Examples are shares in utilities and renewable energy. Reason: The push to lower carbon emissions indicates a bright future for renewables, and utilities will have to upgrade the power grid. Another bright spot is real estate investment trusts (REITs), which are appealing for their more stable, bond-like cashflows, and also currently offer attractive valuations.

The move toward LDI, which Wellington estimates up to 75% of corporate DB plans employ, owes to the fading of the fat days they enjoyed in the last century. And that was even as corporate sponsors began emphasizing 401(k)s. From 1976 to 1999, DB assets expanded robustly, up more than tenfold, US Department of Labor (DOL) stats show.

Then came the dot-com bust and a recession, when the plans lost some 20% through 2002. That was the precursor for what would impel LDI’s widespread adoption. Pension assets came back and rode the stock bull market that benefited from the housing boom of the aughts. The asset base expanded 50%, to $2.5 trillion in 2007.

Unfortunately, this idyllic spell didn’t last. The financial crisis burst onto the scene, and assets shrank to $2 trillion. Since then, assets have rebounded, but as a swelling army of retirees claim more and more benefits, that hasn’t been sufficient. Corporate plans began de-risking.

An added propellant was the Pension Protection Act of 2006 (PPA), which put more pressure on pensions to use LDI. The law mandated 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.

Still, plans are happy with LDI. Said Wellington’s Trainor, “I’ve never met any plan sponsors who regretted it.”

Methodology:

The 2020 Liability-Driven Investing (LDI) Survey combines feedback from two surveys, one that took stock of pension asset owners and a second that examined organizations offering liability management and de-risking services. The asset owner survey gathered feedback on the LDI-related asset allocation, risk management, and provider sourcing strategies employed by responding organizations and received a total of 165 submissions. The service provider survey collected information related to the experience and capabilities of each of the 11 respondents.

Data has been aggregated and organized around industry trends and provider summaries, which includes asset owner satisfaction with various provider attributes/services. To qualify for satisfaction rankings, providers needed to be rated by a minimum of 10 asset owners. To contribute to future LDI surveys or to receive information on reprints or licensing of associated LDI data, please email. For more information, contact surveys@issmediasolutions.com.

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