Liability driven investing is a popular choice for defined benefit pension plans. As the market environment, rate regime and tax codes change, how will these strategies navigate 2018? In this edition of Masterclass, four experts discuss how to understand the shifting landscape.
Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. Liability Driven Investing or LDI is a popular choice for Defined Benefit pension plans. As the market environment, rate regime and tax codes change, how will these strategies navigate 2018? Today I’ll talk with a panel of experts who will help us to understand the shifting landscape. Welcome to the LDI Masterclass. Thank you all so much for joining us here today. So, Owais, I’m going to kick it off with you because I think we have some interesting changes afoot. How have you seen contribution activity and average funded status change over the past 12-18 months? Owais Rana: Great. So what I will start off with is to give you the performance of how the average pension plan has improved its fundedness over the course of 2017 now, then fast forward a little more towards what’s happened ever since the end of 2018. So over the course of 2017 the average pension plan improved its funded status by around 5%. So numerically from 80% to around 85%. And that was mainly driven by a very significant rally in equity markets towards the quarter four of 2017. Interest rates was pretty much benign throughout the year. However, since the end of 2017 we have seen a significant shift in the capital markets which had further improved the funded status. So as we went into January the equity markets continued its momentum in strong growth. However, fortunately for pension plans the interest rate environment also softened up and long end of the yield curve started to move up, which was a goldilocks moment for pension plans which further improved the funded status of the average plan. Ever since we’ve seen some volatility in the markets, we’ve lost some of that ground, having said that since the end of 2017 the average plan is still up about 85-86%. So that’s been the case in terms of the performance at the funding level. Some of that performance had to be contributed to significant contributions that took place in 2017, partly to do with the anticipation of the change in the tax regulations, which exacerbated contribution or voluntary contributions into the pension plan at the back end of 2017. Gillian:Interesting. So a slightly different picture than the last time we met, which would have been earlier last year. Anything else to add on sort of how you’ve seen the past 12-18 months play out? Amy Trainor: I’ll just add that what’s notable about the funded ratio improvement that Owais mentioned is that plans are now just shy of their post financial crisis peaks in terms of their funded status. And that’s an important milestone because I think that signals a resumption of de-risking and resumption of very strong demand for long duration assets. Gillian: So, Amy, I’d like to stay with you for a moment and Owais already alluded to it, tax reform has pulled contributions forward. What are some of the challenges and opportunities associated with this increased activity. Amy Trainor: Sure. So absolutely we’re talking to a lot of plan sponsors who are planning on accelerating their contributions, as you mentioned, in order to take advantage of the ability to deduct those contributions at a higher corporate bond rate. And we think that a lot of those contributions will be directed into long duration bonds. We’re estimating that inflows into long duration assets will range between $40 billion to upwards of $100 billion. So that’s a lot of money chasing a finite supply of bonds, especially in the corporate bond market between now and September 15th, which is the deadline for making a contribution and deducting it in 2017. So what we have been telling sponsors is to be patient and be a liquidity provider. So if you think back to this year for example, beginning of the year there was very little corporate bond issuance at the long end of the curve. But there was a lot of demand. And on our trading desk we saw buyers taking significant haircuts out of spreads just to get invested quickly and in size. Fast forward a couple of weeks and the situation had reversed. Issuers got wise to where the demand was, so they pushed out their issuance to longer maturities. And at the same time there was also a lot of issuance related to M&A activity. So all of a sudden we went to a situation where we had had very scarce supply of corporate bonds, to now there was a liquidity backlog. And plans that were patient and were nimble were able to opportunistically get invested at very attractive spread levels. Gillian: I’m interested to come back to this topic of supply demand dynamics and corporate bonds. But that’s super helpful to help us understand how tax reform has impacted the landscape. Anyone else have anything to add here on how you’ve seen contribution levels change? Daniel Tremblay: Yeah. I think when we think about contributions it’s certainly a fact that they have picked up. And I think the motivation behind it, as Amy articulated, was the tax reform. But as we’ve been saying for many years, these plans have really had to make contributions because the reality is the capital markets aren’t going to bail them out. And when you think about your average pension plan from a year or two ago at 80% funded on average your average plan that even if their dream world came out and you had a 7 or 8% return in equities, a 1 or 1½% rise in rates, the reality is they’d probably tread water over a five year period. And the reason why is because when you think about risk, when we’re thinking about pension plans, not percentage terms, so 80 cents on the dollar trying to keep up with a 100% of liabilities, be careful of those higher rates because that only increases the hurdle rate that we have to face. We’ve got service cost, rising PBGC premiums, so again the bottom line is while the motivation was the tax reform, all along these pension plans needed to ramp up their contributions, because the capital markets mathematically were not going to bail them out. Gillian: And, Dan, you bring up PBGC premiums, Chris, this would be a nice time to talk about where we are here. Chris Adair:Yeah. And just one thing to add on the tax reform, I think one thing that we’re seeing from corporations is that with the un-repatriated foreign earnings, lowering of that tax, it’s another source that the corporations can use to have a way to pay those extra contributions that we’re making. We’re also seeing a lot of corporate debt issuance, very large corporate bonds that a majority of those proceeds are going to actually take advantage of the change in the tax bracket and make contributions to the plan. Gillian:Excellent. And then PBGC premiums, where are we here? Chris Adair: Yeah. So PBGC premiums continue to rise, this year they’re up to $38 per $1,000 of unfunded benefit. We’ve seen that trend continue to go higher. There is kind of an inflationary mechanism baked into that. So it looks like that that will continue to go up into 2019 to approximately about $42 per 1,000 of unfunded benefit. So the continuing cost of having a deficit in the pension plan continues to really require CFOs to really focus on looking at ways to true up these pension plans with extra contributions. Gillian: Anything else to add on PBGC premiums or rising costs? Owais Rana: The only other thing I’d add is even the fixed component of the PBGC premium is going up at higher rates. Since 2012 it’s more than doubled at the end of 2017. So it’s not just the variable component, it’s even the fixed per member component that’s going up at very rapid rates. Gillian: So no matter which way you look at it, it’s going up. Owais Rana: Absolutely, it has. Gillian: So, Dan, I want to come to you, as we look at the scene that we have just set here, what’s the incentive for a pension plan to pursue LDI right now? Daniel Tremblay: Yeah. And I think the incentive’s shifting from where we’ve been in the last couple of years. And it seems like for all of us, I’m sure, whenever we had a dialog for the last five plus years on LDI, it was those fear of rising rates, right. And even though we knew that was a good thing for pension plans, no one wanted to make an investment in front of higher rates. And I think what we have learned from the capital markets is that The Fed controls short rates, and not long rates. And so what’s been very interesting here is that interest rates are essentially unchanged since The Fed started raising rates two years ago on the long end. And if we look at corporate yields they’re actually tighter. So I think the incentive now is not so much to talk about the fear of rising rates, but rather equities. And if you think about where we are in the cycle, we’re getting a little long in the tooth here, when we start to approach what we call late cycle is a fact that historically, equities have had wider dispersion in performance, average returns have been lower. And there’s even some periods where returns were negative. And if we think about what late cycle leads to, it leads to recession, which ultimately is characterized by lower equities and lower yields. And so I think the dialog today has to be, get your late cycle playbook ready, which means you’re de-risking because of a concern that equities might be the pain trade, not rates, like so many people were scared of in the past. Chris Adair: Well, we’re certainly seeing more focus on we like to call it LDI 3.0, which effectively is kind of the whole holistic asset allocation in terms of looking at, not only just kind of moving your fixed income to a longer duration strategy, then looking at various different ways to de-risk transfers to reduce that liability. But now it seems like we’re having plan sponsors really focus on the growth component of their asset allocation as well. So we’re looking at strategies that are related to hedging, kind of tail risk relative to their equity portfolio. And one of the things that, we think structurally is the biggest problem with pension finance in general, as you alluded to is that when you get a recessionary kind of environment, pension finance, if you think about all your liabilities or long duration, and you get an inverted yield curve. So you get kind of a double whammy. Your growth portfolio sells off, but then at the same time your long liabilities are rallying in terms of price. Gillian: Now, Amy, similar question to you, as we see equity volatility picking up and rates on the rise, all be it from a low base, how should pensions be thinking about de-risking and also what are some of the interesting trading patterns that you’re seeing? Amy Trainor:So I think one underappreciated risk, and it taps into some of the points that Dan and Chris made is inflation. So the market over the last however many years, we’ve kind of been in this new normal that inflation has been very low. But we do see leads that point to rising inflation. And then on top of this, think about the two large fiscal stimulus packages that we’ve had over the last couple of months, the tax bill and the budget bill. The US is deploying a vast amount of fiscal stimulus at a point when the economy is operating out or very close to full employment. And that has the potential to be inflationary, accelerating inflation even more than what our leads would suggest. So why does this matter? Well, it matters because that higher inflation would cause The Fed to tighten perhaps more aggressively, more quickly. I agree with Dan, that doesn’t necessarily have a lot of effect on the long end. But most risk assets are priced for a gradual tightening cycle. So I think The Fed accelerating its pace of tightening in response to higher inflation could be very negative for equities, very negative for risk assets. And potentially then we’re in a world where we have negative equity returns, but long rates rising because of inflation. So it’s a little less clear what happens to funded status in that environment. What I recommend is that plan sponsors begin to prepare for the possibility of that environment, look at lower beta equities with more downside protection, look at asset classes such as bank loans that are floating rate and can handle higher rates, and look at absolute return strategies that don’t have any rate or equity sensitivity. Gillian: I feel like inflation is always a case of be careful what you wish for. We were all looking around for it late last year. And now that it might be here it’s something to keep an eye on. Chris Adair:Well, I think Amy raises up a great point, because for so much of the last five to seven years, we’ve been characterized by very low volatility and high transparency, right, no uncertainty. And I think when we think about inflation it’s something that’s really hard to appreciate, especially in advance. And I think the concern that we have consistent with Amy’s view is that what if The Fed gets behind the curve? The Fed has done such a nice job of telegraphing their actions, and here we are in a tightening pattern, yet financial conditions are rather easy because they have provided so much transparency and a lack of uncertainty. So I think if inflation starts to rear its ugly head, as it’s doing, the concern that The Fed may get behind the curve and accelerate beyond expectations, could cause downside to either the shape of the yield curve or what we have seen in equities, and essentially this goldilocks period could be behind us. Gillian: I’d like to go back to a conversation that we began slightly earlier, but maybe drill down a little further into it. And, Owais, I’ll kick off with you, whenever we have this panel, the one question that I feel we’re always asking is whether or not we’re afraid of a shortage in corporate bonds. Is this something that you’re concerned about? And if not, what are the supply demand dynamics right now? Owais Rana: The question comes up a lot. So let’s just put things into context. There are about a trillion and a half dollars of corporate bonds at the long end of the curve in the US. A vast majority of them are owned currently by insurance companies. Let’s not forget the insurance companies, life insurance companies love yield and they love the long end of the curve because of their obligations and pension plans. And thirdly, they’re also owned by international investors. So there are life companies in Asia for example, that love buying the US corporate market, particularly at the long end of the curve for their life books. And those are the three majority owners of that universe of bonds. Now, we have seen a significant amount of issuance that has happened over the last 10 years or so. And it’s a result of low yield, easy to borrow and if this starts to go up how do the dynamics change? Now, one of the issues that we see now is that we’ve got cash coming back to the US. That will spur some kind of an M&A activity and Amy alluded to this. That may then, it may intensify some of the borrowing from the market. We also see the yield curve flatten a little bit. So rather than borrowing at the 5/10 year of the curve, companies are willing to borrow at a longer end of the curve because it’s a flat yield curve. So there is still some supply that will continue to come through because of the dynamics in the capital markets and because of cash coming back in and spurring M&A activity. We don’t feel that if pension plans slowly incrementally add to an LDI portfolio there would be much of an issue. But if everyone, you know, went together at once, yes, of course, we haven’t got enough assets in the market to actually back that demand. So that’s how we see it. Gillian: Chris, how do you think about the dynamics in the corporate bond market right now? Chris Adair: We certainly feel like the supply is still there today. I think you could run through scenarios that if we did get a continued spike in rates or at least as we’ve alluded to now, if the long end of the curve really starts to rise for whatever reason, inflationary or not. You could see a scenario play out where there could be a shortage in terms of bonds. But we’re big believers too that the capital markets kind of adjust itself. So the supply and demand will kind of meet an equilibrium point at some point. I think the other thing to mention is that when you’re looking at long dated corporate benchmarks, in particular, you kind of end up with kind of issues that are in the benchmark. And you kind of have concentration issues around that. So I think that’s something to consider, we talk about LDI, but we kind of never talk about like the implementation of LDI. And really like our clients and our consultants look to us to add alpha to those mandates, right. All these kind of dynamics meet when we talk about supply, benchmarks, investing and long corporates. Gillian: So while we hope that all the corporate pension funds in America watch this program, please don’t go out and buy your corporate bonds all at once is perhaps what we’re trying to say. Dan, and Amy I want to bring you into this conversation too. Any thoughts on the credit quality also available in the market right now? Daniel Tremblay: Sure, I can start off. So I think what we have seen is an increase in triple-B issuance, as we’ve seen a decline in single-A issuance. And so on the one hand you may say, “Well, if corporate yields are really driven or liability is driven by high quality, corporate yields has had a problem.” I think one area where you saw this conversation going is no matter how you quantify it, there is a strong demand with limited supply. And so I think as we continue to see the benefit of expanding that universe, to include triple-B rated bonds, to include what we call non-corporate credit, emerging markets, Build America bonds. Clearly we’ve seen the role that treasuries can play in liquidity management and yield curve positioning. And so I think as we’ve seen different pockets, whether it’s financials or industrials shifting their return profile, the first issue is diversification, the ability to get access to bonds. The second point I wanted to make on this topic is the fact that relative value is challenging. And I think as we continue to put money to work, as people hit their glide paths, make contributions, everything is going as planned. What we’re finding as investors is the opportunities in the marketplace a little more challenging, right. The new issue market is a great way, when we think of the high bid ask spread on long corporate bonds to efficiently put capital to work. And what we have seen over the last several months is that the new issue concession is not really resulting in a positive return, so to speak, after you buy the bonds. And quite opposite, we’re seeing the secondary market spreads widen out to that new issue concession. So certainly able to be navigated, but I think you have to work a little harder in today’s environment, whether it’s dealing with supply or dealing with relative value. Amy Trainor: So one conversation we’ve been having with a number of plan sponsors is funding their long corporate allocations more opportunistically, because of the challenges that Dan and Owais and Chris have described. So what this entails for example is work with a plan, identify what’s the timeframe over which you want to fund your long corporate allocation, say maybe it’s 12 or 24 months, identify that timeframe. Start out by investing in highly liquid long duration treasuries, and maybe long duration CMBS as a placeholder, target the duration to get to your desired duration level. And then have a plan to leg into long corporates over time. But importantly, be opportunistic, so when you have these occasions when the market has too much supply to absorb you can swoop in and be a liquidity provider and be able to access corporate bonds at a more attractive spread if you’re just going in and paying for liquidity at any price. And one of the opportunities that often gives rise to these occasions to be a liquidity provider is M&A related issuance. M&A related issuance tends to be lumpy and the market has a difficult time absorbing it. And so spreads across the universe often rise as a result. And so that’s an example of one type of opportunity that may arise again if you’re patient and nimble. Gillian: And certainly when that may be arising later on this year as tax reform takes effect on the market. Amy Trainor: Sure. Although with M&A, I mean we talked about this earlier, you know, the wild card in supply is M&A related issuance. With tax reform, now that companies have clarity, I think it, you know, companies who are maybe sitting on the sidelines, are more comfortable pursuing deals. On the other hand there are factors such as, you know, the administration’s hawkish tone on some mergers, and as well as a lot of uncertainty around trade policy and protectionism. So I could also see M&A swinging the other way. I think that’s a big unknown in terms of corporate bond supply. Gillian: Now, Chris I want to come to you, and this is a question that I’ll pose to the whole group. What is your efforts with regard to the construction of glide paths? How do you think about this and what are some of the factors that influence the way that you construct them? Chris Adair: Well, first of all we obviously work closely with the consultants. They tend to come to us in kind of a multifaceted kind of role. Some obviously we’re just a provider of long duration beta and as an active alpha manager shop, that’s how they engage us. So we may be part of a broader glide path that, they have already recommended on behalf of their clients. Other managers come to us for kind of customization around liabilities, and creating custom liability benchmarks and indices. And then implementing that as a custom index, run their portfolios too. But in general I think it’s a kind of community effort, so to speak, between your kind of your LDI completion manager or your consultant and the CFO. And we find that, each glide path tends to be different based on what the underlying corporate plan sponsor’s objectives are. Gillian: Excellent. What about Conning’s approach? Owais Rana: So the way we think about a de-risking framework, also known as the glide path is that we want to set up what the target end game strategy is, whether that’s 110% or whatever the percent surplus that a client is comfortable with. We start with the least risky strategy at that point, which will require, obviously given the chunk of bonds it’ll have, a lot of customization to reflect, not just the duration, not the key rate regulation, but also the spread rate duration across the curve against the liability. But that’s our end point. And the metric that we typically use to evaluate the end point is going to be funded status value at risk. So that’s that tail risk event you want to minimize between assets and liabilities such that markets crash you are still within the tolerance level. And then we evaluate where we are today in terms of the asset allocation and we lineally reduce that downside risk at different trigger points. And the trigger points could be funding level, they could have interest rate triggers, if there is a view by the corporate, or it could be just underpinned with time. If you’re making contributions you’re going to put it into a hedging portfolio over time. So those incremental phases will have a funded status value risk number attached to it, which is lineally heading towards that target end game. And incrementally, the mix between growth and hedging will reflect, will augment with that funded status downside risk budget so to speak. Out of that comes what the hedging portfolio will look like and what the growth portfolio will look like. And a hedge ratio is an output as opposed to an input based on that funded status mismatch risk budget. Gillian: And it sounds like the corporates get some say in those trigger points along the glide path as well. Owais Rana: Absolutely. So it’s a conversation between the corporate, the plan sponsor, us and even the consultant of course who is advising a corporate where that is the case. Gillian: And, Amy, what about at Wellington? Amy Trainor: So a similar framework, in our view, a glide path should be designed to ensure that the plan is taking risk only when it’s rewarded for doing so. No investor wants to take unrewarded risk, corporate DB plans are no different. And so the first step in that process, an essential step in my view, Owais here, at a similar step is identify the plan’s target funded ratio. Varies by plan, it’s a unique determination, but simply put, the target funded ratio is the funded level at which the plan has sufficient assets to meet its funding objectives. And so there’s no upside to funding beyond that point. It just results in trapped surplus. And so if there’s no upside then there is no incentive to take risk. When the plan’s funded status is at that target fund ratio it should be primarily invested in a customized liability hedging strategy. When the funded level is below the target, the plan may elect to take risk in order to improve its funded position. But that level of risk should always be consistent with achieving, but not significantly exceeding that target funded ratio. Gillian: Got it. And, Dan, what about at Fidelity? Daniel Tremblay: I mean I think just like in life there’s no such thing as a bad plan. There’s no such thing as a bad glide path. And so I think whether it is a weak form or strong form, whether it is defined by funded status, interest rates or time, I think what’s important is there’s a mechanism in place to number one, think about risk relative to the liability, put in the context of your funded status. And two, there’s now a mechanism to act on that. And I think a lot of people are afraid to take that decision out of their hands. They don’t want to be too mechanical, so then they go to the other extreme and do nothing, which is why we are supportive of a weak form glide path, so at least you’re having that dialog. Because if we all think back to March 09, and the tremendous opportunity and actually de-risking scenario, where if corporate spreads tighten from these excessive levels, you are going to lose in a big way. And I think we saw too many folks that sat on the sidelines as they contemplated till the summer, still thought they were responsive, but yet kissed away many, many hundreds of basis points of funded status improvement because of that inability to act. And so again I think it’s having a mechanism in place that creates the structured dialog to do something about it that’s key. Chris Adair: A successful glide path is one that you have flexibility to implement when hit. I mean it seems like a lot of plan sponsors will put in a kind of a theoretical glide path and then they want to meet and talk about at the next boarding, that kind of stuff. And that just tends to delay the implementation. So really kind of being able to monitor both your asset portfolio in real time, which everyone does, but also your liability portfolio in real time. And then be able to make real time implementations is, in my opinion, one of the most important features to a successful glide path. Gillian: And, Chris, how do you use derivatives in your portfolios? And what’s your sort of overall approach to hedging? Chris Adair: It all goes back to funded status and funded volatility. And again it’s plan sponsor specific. But we tend to, if we have a plan sponsor that has a targeted interest rate hedge, but again kind of say they’re 70% funded, 60% funded, that kind of stuff, they may want to synthetically add duration to the portfolio. And by doing so they can synthetically hedge their key rate duration exposure that way, to take out kind of the interest rate risk in the plan and still kind of leave a majority of the assets in the growth portfolio. As alluded to earlier, we also do a lot of tail risk hedging on the growth side of the portfolio, whether that’s related to direct kind of hedging in terms of put strategies or dynamic hedging strategies to kind of look at the correlations between tail risk and then other kind of risk factors that are conditionally uncorrelated to drawdowns and equities. So that could be synthetic, long duration, be a treasury futures, it could be capturing kind of momentum strategies, that kind of stuff. Gillian: Any, the same question to you, how do you think about derivatives and hedging overall? Amy Trainor: So our hedging framework is based on a belief that plans should customize their liability hedging strategy to address three keys risks in the liability, in this order: interest rate risk, spread risk and curve risk. And for many plans what we have found is that we can achieve a very good liability match, a very low level of funded ratio volatility by blending together standard market indices, corporate and government bond indices in a manner that targets the liability’s interest risk and spread risk. Now, that gives you a close, but not perfect curve risk, so then we take another step and say, “Well, should we apply some type of overlay so that we can tighten up the mismatch along the curve and hedge the liability precisely? Most of the time what we find is that getting that super precise hedge along the curve gives you only a very incremental reduction in funded status volatility, when we run stress tests, look at different curve flattening or steepening scenarios, very low nominal mismatch. So most of the time we tell plans, “No. That adds additional cost and complexity. Target your key risks through, again, interest rate risk and spread risk through blending market indices together. There may be an occasional plan that has a unique liability feature where you do need to use some overlays to tighten up those mismatches along the curve. But for the vast majority of plans, again, a blend of standard indices that targets your interest risk and spread risk is going to suffice, when you factor in any allocation to risk assets, even a small allocation, when you factor in demographic tracking risk, the benefits from precisely hedging along the curve are even more diluted. And so again, the cost and complexity might not be worth it for a lot of plans. Gillian: And, Dan, what about at Fidelity? Daniel Tremblay: Yeah. So I would say I agree with every single word that Amy said on what I would call the completion management or tightness of fit use of derivatives. And again we couldn’t agree more with that thesis. Where we do see the use for derivatives, more so on the duration extension. If we think about derivatives being a very efficient use of capital, and so rather where the completion management comes in at the later stage when you are fine-tuning. In the early stage when you do in your underfunded plan, you want to have that return seeking component. One way that you can increase your hedge ratio beyond the cash bond markets is to use derivatives. So there we would typically use interest rate futures or swaps to therefore extend the duration and improve the hedge ratio. But then again you can also go out into the strips market, which have been very popular in the last couple of years and do that in a more efficient manner where you take the whole operational complexity away from the derivatives. But again, for duration extension, a very powerful tool for completion management, we do feel we can execute on the traditional bond markets just as effectively, and avoid what we would call the false sense of precision from derivatives. Gillian: And, Owais, any overlap with how Conning thinks about this? Owais Rana: [0:31:18] In addition to what everyone has just said, I’d say that we think about it in the context of the overall asset allocation. Does the client want more growth and return? And hence needs levered exposure to interest rates, to hedge some of the interest rate on the liabilities. If the answer is yes in the context of that funded set is volatility? Yeah, we would then deploy what the most appropriate derivative strategy would be. However, I’d like to talk about derivatives in a different context, which is derivatives gives you an interest rate exposure at different parts of that yield curve. It doesn’t give us the credit spread exposure, one of the risks that Amy just talked about. So how about thinking about physically investing in a corporate bond that gives you that rate and spread. And then using derivatives on the growth portfolio for asset classes that you can get efficient exposures, but don’t believe in the alpha, for example, large cap US equities. You can get a synthetic exposure to that asset class quite cheaply and very, very liquid, and physically invest in the corporate bonds that you can’t otherwise get in the synthetic market. Thereby you’re efficiently using the capital in the growth sense and also in the hedging sense, which is another way of looking at derivatives and of course of your pension plan asset allocation. Gillian: Owais, you actually teed us up nicely, so I’ll stay with you for a moment. The next thing I was going to talk about was how should pension plans be thinking about that overall asset allocation strategy, how does Conning recommend that they look at it? Owais Rana:So again, so I go back to the point of in a particular phase that a plan is in, what is the ultimate outcome? We are more outcome focused when it comes to creating a customized solution. And that outcome needs to be thought of as the ultimate objective to get to that completely de-risked form. In that context, whether you’re today or in the ultimate stages beyond, you think about the risk budget that you’ve created through stochastic analysis. And then that risk budget that a plan is comfortable with, you back out what the allocation in growth needs to be and hedging needs to be. Then break those up to make sure that the growth portfolio is orthogonal or is diversified away from the risks of a hedging portfolio. And that growth portfolio needs to then be further broken down to see what that means in different contexts. There’s efficient frontier based strategies. There is risk factor diversification strategies. There is risk parity etc, etc. So there are lots of different ways and philosophies of constructing a growth portfolio. And similarly, on the hedging side you need to make sure that the hedging portfolio that you build out is made up of rate spread, curve exposure, such that when you blend everything together, it gives you, it equates to that risk budget that you’ve outlined upfront. Whether derivatives comes into play or not is again, it’s another tool in the overall mix. It’s a function of, you know, what is the objective and what the risk looks like for a particular pension plan at that point in time. Gillian: I feel like something that’s been echoed frequently throughout this panel has been starting at the end and then working back from there. Chris Adair: That’s right it’s really corporate finance risk budgeting. That’s what’s going on here, right. You’re sitting down with a CFO and the consultant and you’re going through in terms of what’s the impact to my balance sheet, my income statement? And then, all of those kind of decisions at that point kind of get worked backwards. And then the other thing maybe is they may say give you, okay, in three years, in five years, once we get to certain funding we’re looking to, look at termination type strategies here. So really all of those kind of variables come into play in terms of what the appropriate asset allocation mix is. Owais Rana: One of the things I will add though is that, yes, you could build an asset allocation today. What is the likelihood of it getting me to the next phase? That’s another piece that you have to kind of build in that jigsaw. Contributions need to come back in at some point to see, alright, what’s my likelihood to get from phase one to phase two over x period of time? And if I add some contributions, and what levels of contributions will that increase my probability of hitting the next trigger and so on and so forth. Gillian: Amy and Dan, pulling you into the asset allocation mix, how do you think about it? Amy Trainor: Sure. So I really encourage plans to think more about downside protection within all aspects of the plan’s asset allocation. We like to say seek upside by limiting downside. And what that means is that when you have shallower drawdowns then your assets don’t need to work as hard to recover. And that can be very powerful for compounding returns over the long term. And plans have a number of different levers that they can use to build in more downside protection. So for example, in their core equity portfolio they can invest in strategies that have good downside capture, good downside processes. That’s a real easy fix for a plan that’s just wading into the de-risking waters. They can add to bridge strategies, that’s what we call approaches that have both return seeking and liability matching characteristics, strategies like low vol equities, infrastructure, fixed income spread sectors. They can be useful for their potential ability to mitigate funded ratio drawdowns in time of stress. And then finally, downside protection in the liability hedging portfolio is really important within a credit portfolio. You win by not losing and so the ability to avoid poor credits that eventually downgrade or even worse, default, is really critical to the success of your hedging strategy. Gillian: And, Dan, I want you to join in on the asset allocation discussion as well. Daniel Tremblay: Sure. When we think about asset allocation for pension plans it’s really about defining the risk free asset. And so when we think about it, for a pension plan it’s not cash, it’s long bonds. And so we want to frame the whole discussion around that liability, that long bond proxy for the risk’s paradigm. And so we are going to perform a mini ALM analysis or asset liability. We’re going to think about your funded status, your current asset allocation, how do you define downside risk? So different forms of value at risk, surplus volatility and really define that bad scenario. And I think for every pension plan there’s a different pain tolerance for when they think about downside risk. A very strong plan, someone who has a small pension plan relative to the market cap can tolerate more risk. Someone whose pension plan dominates every analyst call has a different threshold. So the thing we want to incorporate is the quantitative side of the equation when we’re thinking about downside risk, stressed scenarios versus the liability. And then we’re incorporating that into the utility function to say, “Okay, how does this upset me? How do I think about that?” And then when we marry the two, that’s how we can think about the steepness of their glide path and maybe where they might need to de-risk in an environment where someone else may not. And when we say de-risk, we essentially mean their stock bond split, hence the asset allocation discussion. Gillian: Dan, I want to stay with you for a moment. Talk to me a little bit about what you’ve seen in terms of pension risk transfer activity, pros and cons versus an option like hibernation. Daniel Tremblay: Sure. And so that has certainly been common. And we were actually participated back in 2012 in the two jumbo deals. So I think we got a good prism into what went on, on the larger side of the market. Since then we’ve seen a flurry of smaller deals. And so I think what I can say is that both the hibernation and the pension risk transfer have evolved. And so in the case of pension risk transfer, I think we’ve seen the insurance companies have a better understanding how to price this risk. I think a better comfort level with the operational complexities of cutting these checks, valuing the liability and everything that comes with that. And so I think the benefit has been that we’re seeing very attractive pricing on retirees. However, we caution folks to think about that as a double edged sword. Because when you think about the spectrum of the whole liability, the reason why you can annuitize those at such a low premium is because it’s a very quantifiable understandable risk. And what you’re left with between actives and to investors can actually mean you have a liability that’s less easy to hedge and more expensive for the insurance companies, versus a window when you could bundle them in and make it almost a package deal. On the other hand we’ve also seen progress in hibernation, where I think many managers have been able to demonstrate a five or seven year track record with a very tight fit to that liability, possibly running tracking error at less than 1/1½%. So I think the good news is the plan sponsors now have an option to say there can be scenarios when pension risk transfer makes a lot of sense. But I think we can also stand up to the insurance companies and say, “You know what, we can also hibernate this.” And for many plans that can be just as cost efficient. And whether it’s philosophical or other reasons that can be the tiebreaker to determine whether or not they want to hibernate or annuitize part of their pension plan. Gillian: Chris, something to add here? Chris Adair: I think other decisions to go into hibernation versus annuitization or even offering a lump sum is, again we talked about earlier the ongoing PBGC premium kind of decision comes into play there in terms of whether or not hibernation is an optimal way to go versus an annuitization. And then I think, we’ve also seen buy in strategies as well and buyout strategies obviously, which again they all have, variable different components. But I think the common theme here with all the strategies that we’ve seen is that there has been certainly a much greater interest in the strategies. And you know, I think most start off with their terminated retirees to again, reduce the liability off the balance sheet. Owais Rana: The only thing I will add is that there has been a lot more activity over the recent past for lots of small balances but a lot of numbers, because it was just cheaper for some companies to transfer that to an insurance company rather than paying fixed fee on PBGC premiums, on these really small balances, it was just an economic way of reducing some of that risk off the balance sheet. Gillian: Now, Amy, I want to come over to you for a moment to talk a little bit about cash balance plans. We haven’t gone into this much. I know that Wellington’s done some research on this point. Amy Trainor: That’s right. So this is a topic that’s been coming up more and more recently. So a lot of plans implemented cash balance formulas back in the 1990s. And now 15/20 years later we’ve reached a point where those liabilities have grown and sponsors are asking, “Okay, how do we hedge these liabilities?” So the bad news is that those liabilities are actually unhedgeable. The good news is that we think we can combine a mix of different asset classes that track those liabilities reasonably well. So just to take a step back, what makes these liabilities unhedgeable? A cash balance formula defines the benefit as an account balance. So that means that the liability looks a lot like a bank account, meaning it has no risk, it has no duration risk, spread risk or any other type of risk. But the catch is that these plans typically promise an interest credit that’s above the risk free rate. So for example, a common cash balance provision is to pay an interest credit based on the yield on the 30 year treasury bond, reset each year. And clearly there is no asset class that has these characteristics. Amy Trainor: And then in addition, the other thing to think about in an investment strategy is that these benefits are typically portable, they’re typically paid out when the participate terminates. So liquidity is important. So while there’s no natural hedging asset class for these types of liabilities. What we found is that by combining a diversified mix of fixed income spread sectors, with agency mortgage backed securities in very short duration treasuries, that blend gives us a nice mix of yield liquidity but with fairly low risk and in our historical simulations, has done a good job of tracking that cash balance liability. Gillian: You’ve done an incredible job of giving us a sense of some of the dynamics that are at play and sort of how you construct your various solutions and glide paths. So I’d like to maybe broaden this back out and start to think about how we benchmark the success of these plans in the future. So, Owais, I’m going to start with you, with the increasing trend toward customization, how do you measure success? Owais Rana: Yeah. So measuring success in a pension LDI program is not a single number. There are a couple of different metrics that need to be thought through. So one is funded status. How that’s performing, there’s assets divided by liabilities, that ratio. Secondly, if you’re looking at the LDI framework by itself then you need to think about creating a customized benchmark that is investable, not the actual theoretical benchmark. But an investable universe of bonds that will mimic or behave like the liability that’s being calculated by the actuary. So that investable benchmark becomes the beta or beta in the US, and then as time moves on, you calculate the performance of that index and see how the value of the liability is mimicking. Third thing is hedge ratio. I wouldn’t say that’s number one, typically that has been number one. I think hedge ratio encapsulates a lot of risk into a single number. But it should be third on the list. So looking at those three components together in terms of, you know, the hedge ratio funded status and the tracking investable benchmark liabilities, you’d be able to see how the liabilities performed against the benchmark. But also how the managers performed against the investable benchmark, because the investment manager doesn’t know what a liability is. He or she needs to be given a particular investable benchmark. So that their alpha or excess return is being measured against that universe of bonds and the benchmark’s performance is being measured against the liability. And that person who structured that benchmark is responsible for that. Gillian: So, Owais has outlined three metrics that he’s keeping an eye on. Chris, are they similar to what you’re looking at? Chris Adair: Just to put it into perspective I think long credit in general is a very hard asset class. And I think if you look at eVestment they have maybe 130 different strategies or managers that report to the benchmark. And over the last three year period only about 37 have actually beat the benchmark. So long duration, long credit, long spread, it’s a tough benchmark to beat. And then when you layer on the complexity of a custom liability benchmark that’s investable, which effectively is, if you just break down what a custom liability benchmark is, it’s effectively, a whole basket of corporate credit until we run out of spread and then there’s a whole basket of treasuries on the tail, so it’s like a custom GC long. But still, you really need transparency there in terms of the way the index is constructed. You’ve got to understand why there is kind of this disconnect between accounting and PPA, which effectively uses single-A, double-A and triple-A corporate bonds to, when they construct the PPA curve. Well, the problem is after about 15 years in duration, or about 30 years in maturity, you run out of corporate bonds. And so what the treasury did back in 2006 when they designed this, they just bootstrapped the corporate bond curve to let it continue out to infinity. Well, that’s non-investable. So you’ve got this kind of like kind of tug of war going on between what the corporation is reporting in terms of accounting versus what’s investable from an asset management perspective. So I mean I think in terms of measuring success it’s hard for us not to sit back and say, “Okay, how much alpha do we generate versus a long credit benchmark? Or how much alpha do we generate versus a custom liability benchmark?” But as Owais said, I think that there are other measures here in terms of really, probably the biggest one outside of traditional asset allocation is, surplus volatility. And we really compress surplus volatility or another way of saying that for corporate pension plans is have we really compressed contribution volatility? Gillian: Dan, what does success look like to you? Daniel Tremblay: I mean I think as think about custom mandates, defining success is a very tough, but appropriate question. Because we all grew up in the [inaudible] mentality where beating the benchmark was a good thing and more is more. And I think as we move to custom mandates, your primary objective may not be outperformance. And it actually might conflict with what you’re trying to accomplish. If your role is to come in and be a completion manager, and therefore your objective is tightness of fit, outperforming a benchmark typically means you have to look different than your benchmark. And you’re probably not tightening or reducing risk. And so I think what’s key is to have quantifiable objective measures of success. So whether it’s a hedge ratio, whether it’s a key rate duration threshold along the curve, or you’re plus or minus .2 years, or different metrics like that. So therefore the board, the asset manager and anyone else involved can pick up that piece of paper, look at the portfolio objective, or I’m sorry, positioning and say, “Okay, are you meeting that objective?” Because it’s very squishy when you move beyond alpha is the main driver of outperformance or as measurement. Gillian: [0:48:40] Is squishy a technical term here? Daniel Tremblay: Yeah, absolutely. Owais Rana: It’s fixed income jargon. Gillian: Over my head. Amy, tell me a little bit about how you think about success? Amy Trainor: So absolutely agree that the liability benchmark, the investable representation of the liability is a key measure of success. And in working with clients I encourage them to measure the performance of their overall investment strategy against that benchmark. That benchmark is the low risk portfolio. So the performance of your overall strategy relative to that gives you important information. It tells you how much you earned by allocating away, by taking risk and allocating away from that risk minimizing benchmark. And then you can do attribution and you can dissect that outperformance. Hopefully it’s outperformance, could be underperformance. You can dissect that into the different drivers, how much of that relative performance was from being under-hedged? How much of it was from your market exposures? How much was from active management of your individual managers versus their respective benchmarks? And then you can have a complete picture of what contributor detracted from success. Gillian:We’re coming to the end of our discussion so I really want to give you each the opportunity to summarize for us, not only your overall thoughts here, but where your particular firm fits in, what is your competitive advantage in the LDI space? So, Chris, I’ll kick it off with you, tell us a little bit about what the Ryan Labs value add is? Chris Adair: We’ve been doing liability investments since 1991. We did our first custom liability index and investment portfolio in 1991. So our understanding in terms of pension finance and how corporate plans and corporate allocations, how it relates back to how to structure an LDI portfolio is deep rooted in our DNA. Having said that, we are again a very focused alpha shop. And so we believe that even if you’re de-risking a plan there’s still room in the portfolio to add excess return. And we do that by really understanding the components of the benchmark. And so that coupled with our derivative overlay platform again that where we focus both, not only in terms of LDI, in terms of key rate durations. But we also focus on the growth side of the portfolio in terms of managing that tail risk, we feel gives us a competitive advantage. Gillian: Owais, what is the competitive advantage at Conning? Owais Rana:So at Conning we’ve been managing assets relative to liabilities for many, many years, decades, given that we’ve been an insurance asset management specialist firm for a long period of time. Most of our mandates are customized, and we want to apply the same DNA in a pension plan context. Corporate pension plans, liabilities do not reflect the same cash flows as a long duration index of a bond portfolio. And therefore we think customization, it makes a ton of sense. So customization is key, we’ve been managing money for a very long time. And thirdly, credit is also a very important component in LDI. And having been managing money for insurance companies, specifically credit oriented has given a lot of course, you know, good performance. And we’re trying to incrementally just avoid downgrades and defaults, that’s been the theme, and buying relative value bonds from the context of excess return. And that’s what we’re applying in our pension plan mandate. And lastly, we have a software business which we actually sell to consultants and insurance companies, and perhaps other asset management firms. And that software we utilized to our advantage to calculate, you know, risk analysis between assets and liabilities that brings the platform together for LDI. Gillian: Thank you. Wellington. Amy Trainor: So I truly believe that our clients benefit from Wellington’s collaboration across asset classes. And I speak to that from personal experience. I’m an actuary who also invests, managing custom glide path solutions for our DB clients. And I believe I can do my job better at Wellington because of the access I have to experts across the capital markets and equities and alternatives, commodities, fixed income. And then I can marry their insights with the actual expertise and experience of our LDI team. So for example, I’ve tapped into a veteran PM at Wellington who has 20 plus years experience investing in companies that own long lived physical assets. And he’s helped me think about the role of infrastructure in the portfolios that I manage. And in our core LDI solutions, it’s the same competitive advantage. I believe our credit analysis is more rigorous because of the equity investor perspective. When one of our credit analysts attends a company meeting he or she hears different insights from management than they might otherwise hear if there weren’t an equity investor sitting right next to them at the table. Gillian: So some healthy collaboration across asset classes. Amy Trainor: Definitely. Gillian:And, Dan, lastly, what is the competitive advantage at Fidelity? Daniel Tremblay: Sure. As I think about the LDI world evolving beyond just good long bond management, I think it’s the ability to speak the liability language, the ability to customize. And most importantly, the ability to take complex solutions and explain them in English in simple terms, because we know that’s going to be very overwhelming for pension boards as they look to customize in a jargon heavy environment. Second, as we see the LDI world evolve, I think it’s much more than just asset de-risking. And so when we think about the integration of liabilities, of actuarial, of DB administration, even the DC plan, all coming together for a holistic pension or retirement experience, I think Fidelity’s ability to have expertise in each one of those underlying components and our ability to seamlessly bring this together so the plan sponsor has seamless communication and integration when some of these interactions may be happening once or twice in a lifetime, that ability to integrate and have that expertise goes a long way beyond just saying, “I’m a good long bond de-risker.” Gillian: And thank you all so much for joining us here today. It was so helpful, not only to get a sense of the scene that you’ve set, but to dive a little bit deeper into the dynamics and technicals here, as you said, Dan, it’s not always clear and easy. But I think you really explained them in accessible terms. And thank you for tuning in. From our studios in New York, I'm Gillian Kemmerer and this was the LDI Masterclass.