MASTERCLASS: Liability Driven Investing - June 2017

Defined benefit plans can benefit from the adoption of a liability-driven investment approach. Asset TV assembled a panel of three experts to discuss some of their best practices when it comes to managing risk and meeting liabilities, as well as to delve into the current interest rate environment and how it’s impacting their investment approach.

  • Greg Garrett - Fixed Income Investment Specialist at Capital Group
  • Owais Rana - Head of Investment Solutions at Conning
  • Dan Tremblay - Senior Vice President, Director of Institutional Fixed Income Solutions at Fidelity Investments

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  • 58 mins 43 secs

Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. Defined Benefit plans can strongly profit from adopting a Liability Driven Investment approach. With the average corporate pension plan exhibiting an 85% funding level, what are the best ways to meet liabilities and manage risk? Today three experts join me to discuss their approaches to Liability Driven Investing and how they are thinking about interest rates in the current policy environment. Welcome to the LDI Masterclass. Thanks so much for joining us here today, gentlemen. So I’m going to tee up quickly with a graphic, it’s the most recent known and 100 pension funding index, it looks like a surplus and deficit since, I believe, 1999. There was obviously the Pension Protection Act of 2006, that was passed over 10 years ago, and yet the average funded status of a US plan is 85%, Owais, starting with you, what are the factors that got us there? Owais Rana: So just stepping back, in terms of the objectives of the Pension Protection Act of 2006, prior to that pension plan, funding was relied upon long term smoothing in terms of how the asset allocation would potentially move and the liabilities would potentially be smoothed out despite the volatility in the capital markets. And around the 2006 time period the legislation was brought in to actually turn that liability into a more mark to market environment, which meant that if the investment rate environment changed then the liability valuation would reflect that movement in interest rate. And in your chart, if you take a look at the 2006 area, around there, there were a lot of blue Manhattan skyscrapers and it was a perfect time for pension plans to actually move towards a more liability driven investment approach. Having said that, what happened soon after that was obviously quite catastrophic in the financial markets. And unfortunately pension plans didn’t move quick enough to actually lock in some of those very nice blue areas that your chart shows. And ever since, the pension plan industry has struggled as the long end of the interest rate environment and interest rate curve has continued to fall despite the, you know, the impetus that the markets or the government has provided over the last seven/eight years ago. The pension plan funding levels have been deteriorating. And most of that, despite equity markets having recovered has been a result of falling long end of the interest rate curve. Gillian: Okay, that’s a great way to get started. Greg, can you give us a little bit of color? Greg Garrett: I would also point to a couple of other factors that have impacted. One is the legislation that was passed in 2011 and 2014 that legislated some contribution relief where they allowed pension plans to begin … some pension plans to opt out and utilize an interest rate that was based upon 25 year averages. This reduced the value of the liability, reduced the value of contributions. And the net effect is that we’ve … some firms have been, if you will, contributing less to their plans as well. We also had a change in the mortality tables introduced by the Society of Actuaries in 2014, which added about 2-3% for the liabilities. But the interest rate factor has certainly been the most important driver here. Gillian: So not just interest rates but people living longer? Greg Garrett: Yes. Gillian: And, Dan, what about you, what do you see? Dan Tremblay: Yeah. I mean I think the panelists have covered it well. But I think one benefit to the Pension Protection Act, because certainly they can’t control the capital markets. And the intentions are very well intended to have people think more about the liability. And I think that’s what it accomplished, right. When we think about the public pension plans, when we think about traditionally it was a total return approach when thinking about LDI. And we now have the liability forming that benchmark and that risk sensitivity. So I think for that reason, while, again, the capital markets haven’t been supportive, I think we have seen the fact that more and more pension plans are slowly thinking more about what it means to measure success and how they measure risk. And both of those have to be defined by the liability. So from that respect I do think it’s been successful. Gillian: And staying here actually because my next question was going to be have you seen a common ground in the way that pensions are approaching their plans when adopting LDI strategies? Do you find that more and more are looking at their liabilities as that benchmark as you mentioned? Dan Tremblay: I do. I do. I think we’re seeing that positive trend. And I think when you think about LDI, it’s really a tradeoff between the return seeking allocation that is required, right. These plans are underfunded; they need return seeking assets to help bail them out. On the other hand we know that rates can continue to fall, they have fallen. So they need bonds to help them de-risk and protect that further downside outcome. And so they’re in this struggling pattern. So what we typically see is the low hanging fruit is to start extending duration, right. Think about that bond allocation, have it work as hard as it can for you and therefore you extend duration further out the curve. I think another common ground is to think about what the end game is for these pension plans. Are you looking to terminate? Are you going to remain open for infinity? What is it that’s really going on there? And once that end game has been defined, you can then start to reverse engineer what is the appropriate risk return tradeoff as you move along your glide path at different funded status levels. Because I think the key point here is that LDI is not all or nothing. It’s not a 100% bonds or not. It’s really an incremental approach to thinking about pension risk management. Gillian: It’s interesting. I feel like so often LDIs are associated with that 100% fixed income allocation. But can you tell us a little bit more about how you’ve seen pensions change their perspective over time? Greg Garrett: I think that when we first saw plans adopting LDI plans in 2006, post the passage of the Act, a lot of plans took their core bond manager and immediately termed out the duration to match the duration of the liabilities. And that made a lot of sense. There were also a number of plans who we saw who were actually trying to be very precise and actually managing to a single A universe. Post crisis it’s been interesting that we’ve seen more plans kind of adopt and be open to taking a bit more of an active approach from managing LDI assets. And you’ve also seen a slight deviation in terms of plans that have been more committed to making contributions. They seem to have taken a slightly different path, have gone more down the path of actually matching their liabilities and assets, whereas those who have not been as aggressive on the contribution side seem to have been less aggressive in that regard in terms of being more precise relative to their liabilities. Gillian: Excellent. And Owais, your thoughts on how you’ve seen things change among the pensions and their point of view here. Owais Rana: Sure. I think the panelists have covered most of what has happened. The only other things that I would add is if you look at surveys, whether they’ve been conducted by consultants or market experts, that in terms of how pension plan sponsors are thinking about asset allocation. If you go back 10-15 years it was more about return seeking. And it has now become very evident that risk management has become the focus of these pension plan sponsors. So that mindset from a total return perspective has now shifted more towards risk management, which is what LDI provides. It’s the company that’s actually sponsoring this benefit is not there to make money off this entity; it’s there to provide income to the retirees. So there is that element of making sure there’s enough money in the kitty as and when it’s due. So it’s more about risk management and downside risk protection than about making money out of this pool of assets. Gillian: Which plays into your point about being benchmarked against your liabilities, which seem to have been a change over the course of let’s say the past 15-20 years. Owais Rana: That’s right. And then alluded to that, our focus has always been that conversation that your benchmark should not be S&P 500-- it should be your liabilities. And that’s what your ultimate objective is. And the trend has been the first phase was to just extend duration, as Greg just mentioned, from your core portfolio. And then the subsequent phases have been more about, where do we now allocate these assets most effectively? Do we use derivatives? Do we use more term structure, allocation approach? We’ve got more managers in the mix, so do we provide a more completion management? So there are a lot of different iterations that have taken place ever since. And I also believe that going forward, as more incremental dollars do come into the hedging bucket so to speak, there will be a lot more customization required than just buying some blunt instrument that’s providing you lower duration, so to speak. Gillian: It will be interesting to discuss customization a little further later. Greg, broadly speaking, we’re going to dive into best practices in a moment. But if you could look at any specific sector or name, who do you think is really getting it right, right now? Greg Garrett: In terms of sectors, when you look around the industry, it’s interesting to see that a number of the banks and number of companies in the banking sector have been doing relatively well in terms of progressing down that glide path. Gillian: Finally something we can thank the banks for. Greg Garrett: And so we’ve seen a lot of progress on the part of the banks. But there have been a number of companies that sometimes are not necessarily sector specific. And we’ve seen some standouts in a number of industries, and this is one of those where it’s hard to make broad generalizations. But if you were I think banks would be one area. You’ve also seen some of the industrial companies have been very active in terms of addressing long liabilities, certainly the auto companies have been doing a lot towards making progress. So those are two areas where we’ve seen companies making progress. Gillian: Great. Dan. Dan Tremblay: Yeah. I think just expanding on those lines, I think what’s been interesting with some of the industrials is they’ve tried to utilize all the levers they can play with, right. So for example on the liability side, we have seen, you know, lump sums, return invested employees. We’ve obviously seen some flagship pension risk transfers where retirees annuitize off into the insurance companies. On the asset side of the equation, obviously have your focus on de-risking and through contributions and de-risking and other factors. They have taken up their fixed income allocation and they’ve really maintained rather a high hedge ratio. And we know that’s served them well in the last couple of years, although that wasn’t the intent. We always try to remind people, this is a form of insurance, it’s okay if rates rise. But if rates fall you’re going to feel good about it, right. No different than when you have car insurance; you don’t get mad if you don’t get a car accident that year. You shouldn’t get mad if you extend duration and rates rise because most plans are still going to win even if those rates rise. But getting back to the question of who’s done it well, I think, again, talking about some of those larger plans, that some of the reasons why, well, we know that some of these pension plans were larger than the overall market cap. We know that it dominates a lot of the conversations on their earnings calls. And so for all of those reasons a more cyclicality nature of their business they can sometimes have the pension plan being underfunded at the worst part of their own fundamental profile. And so I think when you take all of those collectively together, you see that, it makes sense why they’ve focused on these rather diligently. On the other extreme we have also seen some of our smaller pension clients that have actually been the most advanced in their customization. And what comes to mind there is the fact that these are smaller plans, they’re a bit more nimble, less bureaucracy. They didn’t have a lot of alternative investments that may have locked up capital. And so the fact that they were nimble in the last couple of years and then allowed them to de-risk, rates fall further, they’re in a better position, they continue to de-risk. Now they’re at a stage, as we’ve talked about, where if you’re 90-100% funded, 70/80% bonds, we talk a lot about that false sense of precision. It makes all the sense in the world to avoid that when you still have 60/70% in equities. We don’t care about the shape of the liability curve or things like that and a custom discount rate you may have. But when you are now 70, 80, 90% bonds it’s time to start thinking about what we call second order risks. And so we do care about the shape of the yield curve on your liability profile. We do care about a custom discount rate, what we call real implementation challenges and the nuances of how liabilities are calculated. And so the smaller plans have actually succeeded in doing that. So even though we manage money for some very large pension plans, some of our more advanced sophisticated implementations have been driven by these smaller plans, not because they’re smarter and more advanced, they’re just further along in their journey, therefore it makes sense to do that level of customization. Gillian: Okay. So we’ve heard smaller pension plans getting it right, big financials, Owais, who are some of the best in show clients that you’ve looked at? Owais Rana: So from my experience I think the financials have been obviously the best performers where it comes to funded status protection, and they are pretty well funded, compared to the peer group. You know, Dan’s already spoken about some of the hidden gems who don’t come to press. But the SMID market has done fairly well. And from my experience, you know, they have also protected themselves in a pretty tight manner when it comes to funding level downside risk protection. I think the other sector that in my … from my experience, has done fairly well is the technology sector. Some of the really large plans in that market, traditional old plans have also placed themselves in good stead. And I don’t think it was by sheer luck. I think they put a good plan in place since the Pension Protection Act came into play. And then they incrementally moved towards a more systematic de-risking approach whether it’s, to Dan’s point earlier, liability management or whether it’s an asset allocation de-risking approach towards a more protected framework. And I think some of those companies I can think of have done fairly well. Dan Tremblay: I think what’s interesting as I’m listening to these answers, we’ve clearly painted a picture of many winners, so to speak, that have managed risk quite well. But I think we should be clear that the reality is probably more than half the people that we speak to are in a very troubled situation where the capital markets haven’t supported them. The pension relief has not forced them to make contributions, so when they do see the average plan at 80% or so, and we talk about a lot of winners, that tells me that there are people that are in their 70s in their funded status and they’re facing a lot of challenges. And they’re the ones that need the most help. The problem is there’s not a simple answer for them. We cannot just sit around and hope that interest rates are going to rise. At some point these plans are going to have to make contributions. They’re going to have to think more about their liability. They’re going to have to be a little smarter in the way that they manage their assets. But I think the reality is, and I think we would all agree, there are clients along the entire spectrum of strong and more challenged pension plans. And that’s, I think what makes our jobs rather dynamic in this world today. Gillian: Go ahead. Greg Garrett: Yeah. I was going to say I just agree with all that’s been said and the challenges that many plans are facing a contribution hurdle that they need to meet. And some plans have been hoping that we’d see this big interest rate increase that would allow them to move further down their glide path, allocate more to LDI assets and also relieve them of some of the pension underfunded status. But the fact of the matter is that, you know, we may see interest rates increase and then again we may not. So it’s hard to tell. Gillian: Well, you’ve teed us up perfectly because we have Fed decision day hot on our heels tomorrow. Obviously market has all but priced in a rate hike for tomorrow from Janet Yellen. No matter how much we talk about the rising rate environment the fact of the matter is we are still in a low interest rate environment. So, Owais, I’m going to kick it off with you, we are technically seeing some incremental rate rises, so what do pensions need to be thinking about right now? Owais Rana: I mean as we’ve already determined the interest rates are probably the most … the biggest, is enemy number one for a corporate pension plan. But it’s not the short end of the curve, which can be controlled. It’s really the long end of the curve, the average duration of these liabilities that are between 13-14 years. And a 1% change in interest rate brings about a 13-14% change in the liability value, crudely speaking. So as much as we can rely on shorter end of the curve being the controllable part, there is no guarantee that that will trickle all the way up to the long end of the curve. And more importantly it’s important for us to think about how the growth of the economy is going to be spurred, that spits out expectation of growth and hence inflation, that’s going to start moving that long end of the curve more dramatically one way or the other. And it’s anyone’s guess given the environment we’re in today. Gillian: Sure. And the Key Inflation Gauge came in quite below expectations in May, even though we’re getting ready to make some moves or The Fed is committed to making one, if not two moves this year, so that’s something to keep an eye on. Owais Rana: Yes. And also we’ve got, you know, the new government that’s got massive plans of stimulating growth. And whether that goes through via tax relief or infrastructure spending, we will find out. And whether all of that’s already priced in, we also don’t know that yet. Gillian: Yeah, also a good point. Greg, what do pension plans need to be thinking about? Greg Garrett: I think it ultimately just comes down to thinking about more than just one scenario, right, and thinking about as we’ve been discussing, this idea that … just because the Fed’s raising policy rates on the front end of the curve doesn’t mean it’s going to happen on the back end. So after the March decision to raise interest rates by 25 basis points, actually the 10-year Treasury is down 30 basis points. And the other thing to be thinking about is we are late in the economic cycle. And that has implications for asset prices, whether it be bond spreads, which are particularly tight, equity valuations which are relatively high, and leverage which is relatively high. So those are all factors that you need to be thinking about in addition to interest rates when thinking about a scenario for all of your assets, not just your bonds. And so that’s what we encourage our clients to do is think about a group of scenarios and put some probabilities around those scenarios and then begin thinking about how they want to manage the risk around their funded status volatility. Gillian: How much is there a difference in the duration of liabilities across your pension plan clients? Greg Garrett: It probably ranges 7 years to 16 years. So it’s a pretty broad range. And each one of those clients would have a solution that takes into account their funded status level, the willingness to make contributions and also to some extent their view on rates, tends to feed in that as well. Gillian: Okay. And, Dan, same question back to you, not only, you know, how should pensions be looking at this, but then when you look at the duration of the liabilities, how do you help them navigate depending on which end of that they’re on? Dan Tremblay: Yeah. And I think, you know, most of those pension plans regardless of the exact number and duration of the liability, the bottom line, if they’re heavily influenced by that long end though, right. And so when you think about the power of hedging on that 30 year note is where the biggest bang for the buck is going to come. And we have a lot of clients that just psychologically are saying, “I’m not moving until those rates get higher, right, 4 or 5%.” And as we’ve all commented, growth and inflation really drive the long end of the curve. And so we can have fun all day speculating if The Fed moves one or two times in 2017, is a terminal rate end at 3, does it end at sub 2, which is what the market’s telling us, it really doesn’t matter. It’s that long end of the curve that’s going to matter most. And so when you think about even guessing within 30-50 basis points, that doesn’t matter. For that client that’s waiting for the 1-2% rise in rates, I feel very confident saying that they’re going to be waiting for a very long time. And we’ve done an analysis that looked at the drivers. And what we would need to see are structural changes to both productivity and the labor force participation to see real GDP growth get into that 4 or 5 handle which then would lead to a much higher long end of the yield curve. And again, in order for us to see record level of productivity gains that we haven’t seen in 30 or 40 years, you know, the same thing, peak levels of labor force participation, whether it’s demographics, whether it’s where we own the productivity curve, it’s just not going to happen, right. I often remind clients that when you give a farmer and take him from a horse to a motorized vehicle, right, machinery, they’re going to see a 10 x gain in improvement. When we go from an iPhone 6 to a 7 we’re not seeing that same bang for the buck. And so for all of those reasons we can have fun forecasting interest rates within a small range, what some people are paid to do. But at the end of the day that big bang for the buck, 1/2% rise in interest rates, structurally you can feel pretty confident that even though we’d all love to see it, the reality is these structural issues that are pretty legitimate and pretty tangible are just not there to drive the long end, you know, significantly higher to the magnitude that some of these clients are waiting for. Gillian: Well, with this focus on the long end of the yield curve in mind, Greg, coming to you, have you seen that pension plans are meaningfully determining their de-risking strategies in light of all of the changes that are coming down the pipeline? Greg Garrett: Meaningfully? Not necessarily. I think what they’re really focused on is just maintaining that focus on balance between contributions and the overall risk that they’re willing to take. And so I think that it does in some ways go back to this notion of the interest rate strategies or the interest rate views which do tend to creep in to peoples’ mindsets. And that seems to be the principal focus for a lot of people today. And we are again kind of walking them back and saying, “That’s part of this but you do need to be thinking about what if interest rates don’t make this move.” And you also need to be thinking about the fact that there’s a lot of demand that is going to come into the market all at the same time. Because when interest rates move they don’t move for one plan, they move for everybody. And so they need to be thinking about the fact that maybe they need to have a strategy in place. For example, you could fund a portfolio today and if you’re concerned about interest rates going up, you can do an interest rate swap overlay to take out the duration. That way if and when your interest rate view does come forth you do actually have that portfolio full of bonds. It’s been interesting though, it’s been difficult to convince people to take that step. But we think it’s a pretty logical one in this environment. Gillian: And my next question was going to be whether or not capital markets can bail you out. But I’m starting to get the sense that that answer might be no. Greg Garrett: I think it’s a strategy that somewhat depends on hope, right. And there’s a lot of people who have basically been banking on that outcome. And we’re not necessarily, you know, again, get back to the scenarios, think about all the different things that can potentially happen. Gillian: Okay. Dan, now to you, do you see many pension plans meaningfully de-risking their strategies in some way? Dan Tremblay: Yeah. I mean I think we’ve seen a slight lull in the implementation phase. And I think what we’ve seen here is that as people have moved along and number one, the low hanging fruit of extending duration, when we see this scenario, them hitting about a 40-50% hedge ratio with, you know, about an 80-85% funded status, that feels about the right number. And so I think what we’ve seen instead is rather than focus on the implementation today, what we’ve done is we’ve had a record number of client meetings in the last two years really driven by what am I doing next, right. They know they’re going to be de-risking in a big way. They know the end game is ultimately 70, 80, 90% bonds. So if we’re in this lull and they’re in about that right equilibrium of return seeking and hedging well, then now let’s talk about the next round, the next evolution of issues we’re facing. So let’s talk about completion management. Let’s talk about how detailed and fine-tuned does this portfolio need to be, this mythical nature of liabilities. Well, now that this is my real benchmark, and it really breaks every CFA rule of defining a benchmark, the fact that it’s not known in advance, it’s not transparent. It’s not investable. Yet we have, you know, over $3 trillion that essentially are invested against this particular metric. And so again when you have 40% bonds, that’s not today’s worry. But when you know you’re ultimately going to get to 70, 80, 90% bonds we have to start thinking through those issues. Pension risk transfer, is that in your journey or not? And that has ramifications for how what you might be doing today to set you up for those subsequent years. So I think for all of those reasons, there’s a lot of activity, there’s a lot of dialog. But the hardcore implementations, for those that have hit that equilibrium spot; it’s hard to [inaudible] upon and tell them that they’re completely off sides. But at the same time they can’t be sitting on their hands because there are going to be decisions that need to be made. And if and when those rates move, those capital markets, that contribution comes from the CFO, you’ve got to be ready to implement and you need to know exactly what you’re trying to accomplish. Gillian: But the capital markets will not bail you out? Dan Tremblay: I mean the way we’ve looked at that is we try to separate the argument of, well, what will happen in the capital markets, right. None of us know for sure. But what we did was we did an analysis, has been quite powerful with our clients. And we looked at your average pension plan; there were 65% equities, 35% bonds. They are about 80% funded. And we said, “Okay, let’s play out the magical scenarios that you think are likely to happen.” And so in that scenario we looked at what if rates went up 150 basis points on the long end, corporate yields, and equities did 8% per year over the next five years.” And they’re getting all excited. I’m saying, “I agree with you, this is a good scenario.” Over a five year period their funded status is unchanged. Now, some will say, “Well, how can that be?” And what happens is we all spend time on the back of a napkin doing a quick shock, as you said, to liabilities, rates go up, liabilities fall. I’m in business. When we really think about pension risk management, the first key point is we’re looking at risk in dollar terms. So when you have 75/80 cents on the dollar trying to keep pace with a 100% of the liability that’s growing at 4%, that’s an uphill battle. Then you factor in PBGC premiums, clipping away at 3, ultimately 4%. And then finally I think one key point is be careful what you wish for. Because the beauty of low rates is that that liability is only growing at 3½/4%. And so we purposely did this analysis over a five year period to try to offset that instantaneous shock that is beneficial. And so when you see that that liability is now growing at 7/8% in years four and five, all of a sudden you realize, again factually speaking, the capital markets, it’s nearly impossible to completely get bailed out from the capital markets, even at a 3% rise in long rates and an almost 12% return for five years, that’s what barely got you to fully funded status. So what is the punch line to this longwinded answer? That at some point you need to make a contribution. All we’re suggesting in that scenario for plans is we all want the capital markets to help us out. So fund yourself up to something where there’s a better pivot point. Maybe you fund up to 90%, and now the capital markets can work a little better because some of those dynamics I mentioned are a little more favorable at 90 cents on the dollar rather than 75-80. Gillian: And, Owais, take us home, when you think about how your pensions are meaningfully de-risking or not, what do you see right now and are they relying on capital markets to bail them out? Owais Rana: I think plenty has been said on this. And I completely agree with what Dan and Greg have already commented on. When we have our conversation with the clients, it’s about, you know, what is your end game? Understanding that and then building an ultimate end game strategy and then working back from that. And it was discussed already earlier. So in terms of the de-risking strategy our pivot is more about that downside risk management. It’s not about targeting a hedge ratio without knowing what your overall funding level of downside risk is. And part of that is educating, what is that tail risk made up of. And more often than not you will see that a lot of clients actually don’t know what that tail risk is made up of. And when you peel the onions there are a couple of things that come out quite magnified. One is the liability risk, so a lot of duration exposure on that liability side of the balance sheet. And then you’ve got a lot of equity volatility. So those two components make up vast majority of that tail risk. So our conversation then is how do you then think about downside risk budget and which risk do you want to get paid for, invest in that. And what risk you’re not getting paid for, hedge that out. And liability typically is an area where you start to kind of think about hedging. And your de-risking path is built up on that framework of downside risk management, the tail risk and you back out from there based on how you feel comfortable, exposing yourself a tail risk, what is the allocation between your growth and hedging. And then what is the most effective use of the capital in both those buckets. Gillian: Yeah. I think that’s a really interesting point about the anatomy of tail you find that a lot of clients perhaps don’t quite understand what they’re getting? Dan Tremblay: You know, I think what’s interesting is, and I’m assuming you guys are going to agree with me here is that we spend almost every meeting for at least 5 to 10/15 minutes going back five years, debating the level of interest rates and what are the drivers that are going to make them go higher. And they can’t possibly fall from these levels. Yet we never spend any time talking about FANG or the overvaluation of stocks or just the fact that it’s run so long. So rates seem low by historical standards but yet we don’t talk about the five year growth that we’ve had in equities and how that may feel for someone that’s significantly overweight equities relative to their liability. And so to me the whole discussion on risk management and tail risk management really comes down to two questions. Can rates fall from here and if they can is that a pain trade that you can or cannot handle? And the reality is there are some pension plans we deal with that might be hedged enough that they say, “That’s not going to bother me.” Or, “Possibly my funded status drops but we could write out a check tomorrow and we’re not going to lose sleep over it.” And so to us this is how we’re able to raise money, and more importantly, successfully implement de-risking strategies when rates were at 2.75, 2.80, 290 on the long bond in basis points, because at the time there was more deflation scare. Going Japan used to mean you’d stop at 2%. And now we look at so many negative yields across the globe and the fact that the US with our low rates continues to out-yield other regions by 150-200 basis points. It tells me in a geopolitical scare and a deflationary scare and the fact that we’re getting late cycle in a lot of these economies, I don’t know that it’s a huge risk, but that risk is greater than zero. And just like any insurance in your life you need to kind of weigh the severity of the probability and come up with the right dollar amount that you think you need to hedge. And while it sounds corny, the reality is each pension plan has to think about that idiosyncratically. But to me it’s why you need to have a hedge ratio greater than zero. Maybe not a 100% in this environment, you know, we don’t want to seem like bond guys just talking their book. But there is something to be said about managing that downside risk and quantifying both the magnitude and the probability. Greg Garrett: So one of the charts we will put in front of our clients is a 140 year history of the US 10-year Treasury bond. And what people are mostly formed by and at least their views are formed by the last 30 or 40 years because that’s when people have been in the industry. But we’ve had long periods where the U.S. 10-year Treasury was below 3 and traded below 4% most of that time. But from 1933 to 1953, which was a 20 year stretch, U.S. 10-year Treasury traded below 3%. So again, driving home that idea that if you think about tail risks, that’s one that I know people don’t seem to apply enough of a probability weight to. Gillian: Interesting, yeah, that’s a major important point of tail risk that we need to discuss further as well. I want to quickly pull up a graphic that talks a little bit about how many pensions are allocated right now. And we’ve referred to a few times about some of the risks associated with the equity markets. So let’s pull this up, it’s called dialing down risk, I sourced it from Bloomberg just about a week and a half ago. Pensions are selling equities and buying more corporate bonds. I want to talk not only about that trend in general, but, Owais, starting with you, is there a possibility of a shortage in the bond market given pension interest right now? Owais Rana: Immediately, no. And my view is that there are plenty of corporate bonds out there that incrementally the market can handle. Now, if, you know, $2 trillion out of the 3 trillion move into corporate bonds tomorrow then yes. But I don’t envisage seeing that happening in the near future. But incrementally I think the market will be able to absorb it. And if there is demand at the long end, and remember, it’s not just the pension plans that are investing this, there are insurance companies that own majority of the long investment grade market. And pension plans own perhaps around $200-300 billion of that long end of the investment grade market. So as the demand continues to increase there will be downward pressure on the long end of the curve which if companies haven’t really reified, which majority of them have at the long end or would like to kind of reify a cheaper rate, there’ll continue to be cheaper borrowing in the market. And you know, theory would suggest that companies will continue to come in and issue bonds at different parts of the long end of the curve. So that’s kind of my summary in terms of whether there’s enough bond supply demand. Gillian: Sure. Now when you look at the equity investments we see a big drop off, not surprisingly, 2008 and then remains somewhat steady but there’s just this general perception that we’re in the late innings of a bull run in the equity market that something’s got to drop. Should we continue to see these equity investments trend downward do you think among corporate pension plans? Owais Rana: You know, the way I would look at this is go back to my earlier point which is I want to look at my downside risk. What is my equity allocation in the framework of a funded status distribution with the probability and look at my value at risk measure? And if the equity component is significant in there, am I comfortable living with that or should I be diversifying away some of that equity into, not hedging, but other growth type assets that are not matching my liabilities if I’m happy with the split between my hedging and growth? And that’s the way I would think about whether I’m comfortable with where the equity allocation sits. And look at it from the risk budgeting perspective rather than valuation because who knows what happens with the equity markets tomorrow. Gillian: Sure. We certainly do on Friday and the NASDAQ told us everything we need to know there. Dan, go ahead, give us some general thoughts about this picture, but then I’m curious to hear also about the idea of a corporate bond shortage coming [inaudible]. Dan Tremblay: Yeah, absolutely. I mean it’s a relevant topic that’s been really brought up in almost nearly all of our meetings. And I think while we’ve always talked about being aware of this potential imbalance, I think things are feeling a little bit tighter today than they had in previous years. And I think we look at corporate issuance, has been, you know, over $1 trillion the last three or four years, on record pace again this year. But we’ve actually seen a decline in the long end of the curve in issuance from that part of the curve. So interestingly, even though demand is there, no doubt, it’s a relative game and there is even more demand inside five year part of the curve. And so for that reason we’re seeing a lot more issuance coming at that part, depending on where we go with potential tax reform. We’re seeing a lot of indications that issuance and leverage is going to decline on the margin. Well, how are they going to get there? One way is going to be issuing fewer long bonds and just letting them roll down the curve. And so the bottom line is I think, well, it’s not broken yet per se, I think there is a high sensitivity that there is a supply demand imbalance brewing. One way that we get more comfortable, and this has been our answer for the last several years is the fact that, you know, the reality is that you need more than just double A corporate bonds to hedge that liability, whether it’s the imperfections of the liability that require you to own a broader universe of bonds, to the fact that the maturities are more than just long bonds. So early on in the journey there is no doubt, targeting that 30 year note is where you’re going to get the biggest bang for the buck. But when we talk about being 70, 80, 90% bonds, now you do start to care about that distribution of cash flows along the curve, therefore you need 7-10 year bonds. You might need triple B’s and single A’s. You might want to look at non-corporate credit; treasuries always play a role in a hedging portfolio. So all of a sudden this $1 trillion long corporate high quality bond market, you add a trillion from the 7-10, you add a trillion from the triple B’s, you add some non-corporate credit treasuries, all of a sudden you’ve got a $3, 4, 5 trillion dollar universe. And then when you layer on the fact, as you mentioned, that this is not going to be everyone jumping in at one moment, it is going to happen incrementally, you start to say, “This is more digestible.” But having said all that, do we have to keep our eye on the fact that supply has been a little finicky? Absolutely. Gillian: Okay. So not an immediate concern but certainly one to think about? Dan Tremblay: You have to be aware, absolutely, that’s the word we use; you have to be aware of it. Greg Garrett: Well, even that equation is probably driven to some extent by the level of rates, right. So a lower interest rate environment, we might not see much of a change in that issuance. And it is challenging I think to see net issuance potentially pick up from here, only because the level of debt where we are today from a corporate perspective now, interest costs are low, but the level of debt is relatively high. And in a low interest rate environment or say steady where we are you could potentially see that begin to trail off a little bit. But you’re not going to see much demand potentially out of LDI because interest rates are kind of stable and it’s dependent upon contributions. In an environment where rates, let’s say we do get the 10-year back up to 3%, that’s an environment where maybe you do see a bit of a slowdown because interest rates are higher. You do begin to see a bit of a slowdown in net issuance, but demand is going to come in. We have a number of plans that we work with and consultants that we work with all have said the same thing, our clients have two triggers. They have a funded status trigger, but they also have interest rate triggers. And that 3% on the 10-year is a big one. And when you think about that context or that figure, which is Fed data that supports that graphic, it basically shows you that defined benefit plans today have about $560 billion in corporate and foreign bonds out of $3 trillion in assets. Arguably they should be at least at 50 as their funded status improves and again, using the math, you get interest rates up by 70 basis points, the funded status is going to improve by, you know, by close to 4, 5, 6%, so get you up close to 90%, demand is going to start to pick up. And you could start to see an imbalance at higher rates, which is kind of going back to what I was saying earlier about why it might make sense to get your bond portfolio onboard now, hedge out the duration and just wait. Owais Rana: It’s quite interesting though, you know, a 10 year treasury rate, 10 year duration is about what, seven years? Greg Garrett: Seven years. Owais Rana: Liability duration is about 14 so, you know, I would say that if anything, you need to be thinking about putting a trigger on a 30 year, as opposed to the 10-year, just the math doesn’t work otherwise. Gillian: Yeah, good point. Speaking of hedging because you’ve all just referenced it in your last answers and Dan, I’ll start with you. Do you find that the methods of hedging among these pension plans have become more sophisticated or interesting over time? How has it evolved? Dan Tremblay: Yeah. I mean I think it’s evolved in a few ways. It’s evolved as folks have moved along their journey. So as we’ve talked about the low hanging fruit of going from an agg mandate, core, core plus, out to a long of credit, makes a lot of sense when you still have a fair amount of equities. And so the treasuries, although they’re not part of your liability benchmark, they’re a nice tail risk mitigator when equities sell off. And then as we’ve found people start to move further to say a 50/50 blend of stocks and bonds. Now they start to favor a little bit more corporates. As we’ve continued along that journey we start to care about some of the key rate duration positioning across the curve. And then the end game is where we’re really fine-tuning. So to me that’s been the evolution of the customization. I think the other key point is that we’ve all gotten a bit smarter and operated more on the real world of these liabilities. I like to say the whitepapers have turned into a real world. Gillian: Well, we were operating before. Dan Tremblay: Exactly. Well, it was more just a whitepaper, whiteboard practice, right, and you didn’t have the real world implementation issues. And so as we’ve all gone to work in our laboratories in the capital markets and understood where some of those key rates are hard to hedge, one of the best instruments, you used to go through a couple of unique downgrade cycles, you start to see how these liability curves move around. You understand how they operate in the capital markets. And again, one thing that we have learned from this is that if you have a double A corporate bond universe trying to keep pace with a double A corporate liability, you’re going to lose. You’re going to have high tracking error and you’re going to underperform in dollar terms cumulatively over time. And so we’ve learned that from investing from studying these liabilities. And so I think the capital markets, I think the practitioners; the plan sponsors themselves understand liabilities a bit better. It’s still not perfect in that it’s fully engrained in everyone’s DNA. But one thing that we’re trying to do is simply show them the liability on a weekly basis. Everyone looks at the S&P; everyone looks where the 10 year is, you know, where the 30 year is. But ask them whether liability moved week over week, they have no idea. Gillian: If you’re benchmarking to your liability it better be the next thing you’re looking at. Dan Tremblay: You’ve nailed it. And so for that reason, I think just as simple as getting that in their lexicon, in their risk management lexicon, the transparency of the daily, you know, of the valuation, that is going to go a long way in changing their mindset. And five years ago, again it just felt like to summarize this more academic, now I think there’s more of that real world implementation of understanding the pros and cons of these mythical liabilities. Gillian: Owais, do you agree, do you find that hedging has become more sophisticated or real world oriented as Dan alluded to over time? Owais Rana: Yes, I absolutely do agree with that. And we’ve seen that through the de-risking phases that pension plans have evolved into and learning more about how the markets work. And the fact that the liability is made up of a credit curve means that you can’t just theoretically go and employ that investment strategy that replicates that credit curve. It’s a lot more real world, to Dan’s point, than theoretical liability, actual or valuation. But when we have conversations with our clients, and what I’ve seen in terms of planning, it’s about, again, when you look at that VAR number, the downside risk number, the first step is loss of equity vol, short duration, de-risk, allocate to very long dated bonds and take assets our of equities. You reduce that first order effect of massive mismatch between assets and liabilities. Then your VAR starts to come in, the next order of risk management is more about credit spreads and then across the term structure. You’re starting to reduce the leftover risk within that vol as much as possible from a fine-tuning perspective as Dan mentioned. And within that spectrum pension plans don’t just give all their assets typically, especially the larger ones to one manager. You have to think about alpha, you know, risk management from a diversification perspective. So the next layer is how do I quarterback this whole thing? And the definition of completion management comes in. The first iteration was just buying some blunt duration across the managers’ positions by one manager. Now what we’ve said is, “You could actually employ some of the credit components across the different parts of the curve as a completion manager.” So building in the, the spread component at different parts of the curve as a completion manager is again another fine-tuning exercise as pension plans become far more funded and hence have more assets for hedging purposes. Gillian: Excellent. And, Greg, how have you seen this evolve over time in general? Greg Garrett: In general most of the plans that we work with have defined their liabilities in the context of a publicly traded benchmark. And so that it does a reasonably good job of mimicking the behavior of the liabilities. And what we’re really focusing on is efficiently managing the risks around that benchmark. And oftentimes we will work with a client to think about potentially a tracking error – a tracking error budget around that benchmark. And again it’s another way of approaching and thinking about the risk relative to the liability. We can also do that in a custom liability context. We haven’t seen too many folks take that approach; it’s been more of applying a publicly traded benchmark or a combination of them to that liability. And then as they improve their funded status, make contributions then we find that we start narrowing that tracking error relative to the benchmark. But you want to do it in a way where you’re thoughtful and still allow for the management of the bonds to protect you against things like downgrade. You want to be able to try and add value within that bond portfolio. You don’t want it to be just a static allocation that is trying to track the liability. You want to do things above and beyond that because the bond market is very dynamic. And there’s lots of different opportunities that evolve every day. And so we think it’s important to actively manage the bonds within the context of risk. Gillian: Okay. Dan, you just alluded to the fact that we haven’t mentioned PRT Pension Risk Transfer, can you give us a little bit of a sense, [inaudible] is a journey, where along the journey you might be thinking about this and what are the investment implications of it. Dan Tremblay: Absolutely. And I think just to set the right context for everyone, you know, when we talk about Pension Risk Transfer, it is a market development that’s really taken hold in the last four or five years, really in 2012 with a couple of jumbo transactions. And while they certainly have been done in the previous 20 years, really the current state of the market was defined with those breakthrough transactions in 2012. And what it’s really doing is giving pension plans an option to say, “I can manage this off to the sunset, maybe I’m an open plan, maybe it’s just an important part of our DNA.” And we want to continue to offer that. And as such we should manage it properly with the right risk management. But for others there’s an opportunity to do some or all of their pension plan, we’re able to get that off to an insurance company, essentially wash their hands of the liability yet the participant is still getting that safety and that steady income from an insurance company who in some instances might be a better situation for them. But nonetheless we’re seeing this trend towards that optionality. Do I want to keep this on the books or do I want to give it off to an insurance company. And so when it comes to that there’s things that these plan sponsors should be thinking about. And this is a transaction that they will likely do once or twice in their lifetime, if at all. And they’re competing against insurance companies that do this for a living. And so some of the things they’re going to want to think about is number one, what is their starting point, right. Are they significantly underfunded? Is this something where they’re going to have to make a significant cash contribution? Does that influence the time? Is there a hedging component that they’re going to have to deal while they’re waiting for this deal to ultimately close? You can think about the timing, again is it right around the corner? Is it three months? Is it one year? The size of the deal that can have a lot … a huge influence. The size of the deal can influence a number of insurance companies that might be interested. So if you’re looking at a jumbo deal north of $5, 6, 7 billion, there might be two or three insurance companies capable of bidding on your plan. If you’re down under the $2 billion range there could be 12 to 14. It could also influence your delivery portfolio. A smaller transaction is going to have more options so you may actually be building an all cash portfolio. You might be building something we call bond light, or you might be building something very specific to your liability. And now if you compound the fact that it’s a large transaction, now over a short time period now you start getting blended considerations. The last key point is your asset allocation pre and post transaction. So if you’re doing a partial risk transfer, which is very common, right, target retirees, the most efficient cheapest to hedge, therefore the easiest to unwind to an insurance company. And in that scenario when you pay out those ultimate assets for delivery to support the liabilities you may have a different asset allocation. You may have a different hedge ratio, a different funded status. And so it’s very important to think about your liquidity, your hedge ratio and your asset allocation both pre and post transaction. So the bottom line is you can tell from this dialog, there’s a lot for these plan sponsors to consider. And again the key point for me is that this is something you’ll likely do once and you’re facing off at someone who is best in class and does this for a living. And so for that reason you really want to think through a lot of these issues. Gillian: You’d better get it right. Owais, what do you think about this? Owais Rana: Yeah, I think Dan’s probably hit on every point that one can think of on this topic. But I think from my experience in the past where we had built annuity ready strategies, there’s a lot of planning that goes in it. And there’s the practical implications, because there’s a bond portfolio and then the transaction is being negotiated with an insurance carrier on the side. What happens before and after needs to be considered quite significantly. To Dan’s earlier point, you strip out the cheapest insurance members which is retirees, especially men, they live shorter in life than women. But you take the retirees out, what happens next? Typically your duration of the left of a liability goes up, because the longer, you know, deferred members who are younger are going to have a longer duration typically. So don’t forget that as you’re stripping these assets out of your portfolio asset allocation to the … passing either in kind of in cash to an insurance company, don’t forget that the leftover stuff needs to be thought through in terms of what the best LDI strategy for those members will be. And typically you’ll have to extend duration and think more about protecting that downside risk again in the context of leftover obligations. Gillian: So a range of important considerations, Greg. Greg Garrett: The only thing I would add is that it seems that pricing tends to be more favorable in situations where you’re delivering a cash bond portfolio to the insurance company, and that’s what they’re really looking for. And so that’s what, you know, for us we’re getting 90/95% of our duration from those cash bond portfolios. So those transactions are very easy for us to do. Gillian: As we’re coming toward the end of our discussion I really want to ask each one of you a specific question about each of your businesses. And, Dan, I’m going to start with you, your business has grown by 8 billion in the last three years, talk us through how you scaled up that quickly. Dan Tremblay: Yeah, absolutely. And I think it’s as we’ve talked thus far, everyone’s at a different stage of their evolution of LDI. And so what we’ve tried to do is have a solution for each person at each segment. And so for example, just utilizing our fixed income platform we have been able to go out and do the early adopter fixed income allocations where it’s more of a traditional bond search and you have a good long of credit, a long corporate strategy. At the other extreme we’ve participated in a fair amount of pension risk transfers where we have helped on a couple of jumbo deals. We’ve worked on some of the smaller deals and they each have their own dynamics, right. That’s one topic we haven’t talked about yet. But the preparation and analysis that goes into, eventually handing that off to an insurance company requires a lot of work. And each situation’s a little different. There is things that you can do to make sure that you put yourself in a good position because it’s a transaction you’re typically not going to do more than one time in your life. And so for that reason, and the insurance companies are doing it constantly and so you want to make sure that you can face off with that. So we’ve been able to partner in that situation. And then in the middle, just that ability to help with the completion management, to think through the implementation. If a large pension plan ultimately has to move billions of dollars in the long end of the curve, how do they want to do it? How do they want to sequence it? How do they measure success? And so again I think we’ve been able to grow by having a solution and an investment process, a resource development that we can focus on each client’s needs depending wherever they are on the journey, because again that’s what makes this dynamic. This is not a one size fits all approach. Gillian: Greg, when I think about yourself, you’re obviously a fixed income specialist, Capital Group has a lot of active fixed income solutions, is there a role for active management in LDI? Greg Garrett: We really do think there is a role for actively managing the LDI assets. And we think that you can target that desired level of tracking error relative to the liability. And we think that you can add value through issuer, sector and industry selection. We have 35 credit analysts who collaborate with 150 equity analysts. So we really get that complete picture of a particular credit. The bond markets do not perfectly line up with the liabilities of all the plans that are out there. And so we’re constantly in that process of optimizing how the portfolio should be structured from a risk perspective relative to the liability and then the structure of that liability. And you know, I think that, you know if you look back at the history that we’ve seen in the last 10 years, if you had invested in only a single A and above type portfolio, you would have seen a lot of downgrades in things like banking and telecoms. And those downgrades are difficult because they drop out of the discount rate but they don’t drop out of your portfolio. So we think it’s very important to protect against that. But at the same time, design a solution that is sensible and is in line with the risk tolerance of the plan sponsor. Gillian: And, Owais, ending with you, talk us a little bit about your educational model. You have a pension risk analyzer, I know we talked through it on the phone just about a week ago, but can you tell us a little bit more about how you educate your pensions, about how to think about risk tolerance. Owais Rana: Certainly. I think one of the things that I have learnt is that understanding of LDI varies from one end of the spectrum to the other. And we felt that providing an easy to use tool and give it to the hands of the end user, including the intermediaries to help them visualize what it means from managing LDI or managing risk on a liability based strategy. And then that helps them understand to some extent what the concept and the objective here is. The easier the better, more pictures, less numbers. And I think that just doesn’t go in the first … establishing what the LDI concept is but also in measuring success. I think in our industry we have a lot of very bright technically robust people. What goes amiss is making sure that the end client who is not necessarily a financially savvy individual, they’re busy doing their day jobs and their businesses and making cars or tires etc., need to be informed how well they have done in terms of their decision making. And I think that was the motivation for us to kind of provide this tool to the industry. And backed on that it also defines our philosophy about building LDI strategies on a downside risk insurance type spectrum, understanding where risk is being taken within that downside risk, tail risk event. And then hedging assets or using the hedging assets most effectively to reduce that tail risk as they continue to evolve over a de-risking spectrum. Gillian: So you can have the most brilliant strategy, but being able to translate and educate is among the most important, which is hopefully what we’ve gotten to here. We are at the end of our discussion and I want to thank all three of you for joining us. This has been really helpful in understanding LDI, not only in general but in the context of the fixed income interest rate environment that we’re in right now. So thank you. And thank you for tuning in. From our studios in New York I’m Gillian Kemmerer, and this was Masterclass. Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value. The statements expressed herein are based on the date noted. Statements also include the opinions and beliefs of the speaker(s) at the time the commentary was recorded and are not intended to represent the opinions and beliefs of the speaker(s) at any other time. This information is intended merely to highlight issues and is not intended to be comprehensive or to provide advice. Permission is given for personal use only. Any reproduction, modification, distribution, transmission or republication of the information, in part or in full, is prohibited. 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