The year 2016 presented a bagful of unexpected causes and effects for the investment world but repeated a familiar message to sponsors of defined benefit (DB) pension plans: You have to protect your funded status. During the first half, broad downward moves in interest rates raised valuations of benefit obligations. Stocks ended the period more or less flat, and the net result was a fall in the funding positions of many plans, reminding sponsors of the value of hedging through liability-driven investing (LDI).
The year’s second half ended in the “Trump rally.” The rising tide lifted all pension boats—through a boost in stock prices and higher interest rates (Figure 1)—and a retracement in funded status to higher levels (Figure 2). According to estimates by BNY Mellon, the typical corporate plan ended last November with funding of about 82%, up from 76% in June.
“Equity markets moved north, and there was finally the pop in interest rates everyone had been expecting for a long while,” notes Gary Veerman, managing director in the client solutions group at BlackRock in New York City.
LDI programs dedicate a material portion of assets to fixed income, which has returns intended to match fluctuations in liabilities and follow a predetermined glide path that takes advantage of favorable market moves to shift that glide path out of risk assets. The strategy has become widespread, with popularity still increasing. Consultants NEPC conducted a survey this past August among 184 plan sponsors with a mean plan size of $1.6 billion and a median of $750 million. Findings included that 69% of corporate sponsors in NEPC’s sample had adopted LDI, an increase of 12% from the firm’s study a year earlier. And sponsors within that group have become more serious about hedging: The proportion of plans with 50% or more of their portfolios in LDI strategies increased from 9% in 2011 to 36% by last year.
Of the plans surveyed by NEPC that had not adopted LDI, many were averse to locking in such low yields and were holding out for higher rates. The year-end 2016 surge provided a sigh of relief, and the prospects for further rate hikes in 2017 could get them off the dime.
“Given the recent increases in yields, I imagine some plans will revisit their positions,” says Adam Levine, senior investment strategy consultant in the New York City offices of Willis Towers Watson. “Rates ended 2016 just a bit higher than where they started the year, but such a sudden shift is likely to trigger action from sponsors.”
Although the markets of 2016 may have surprised many investors, the results of their LDI programs should not have, observes David Eichhorn, managing director of investment strategies at NISA Investment Advisors LLC in St. Louis. “The move in rates was significant and quite rapid, by any standard, but the strategies have operated exactly as expected.”
As the higher interest rates of year-end 2016 may provide heretofore reluctant sponsors with an entry point, they give others the opportunity to move closer to the endpoint of full funding. So far, though, LDI-oriented sponsors have yet to react with convincing moves in their portfolios one way or the other.
“Because the rate move happened just at the end of the year, sponsors are still evaluating where they are on their glide paths,” says Ankit Agarwal, a quantitative research analyst at Loomis, Sayles & Co., in Boston. He adds, “We have seen a couple of capital additions to LDI hedging portfolios, and a couple of clients have taken off the hedges they had in place. But we should see more activity in the first quarter of 2017.”
Sponsors that are determined to increase hedging against their benefit liabilities, but that find bond yields too skimpy, nevertheless have tools at their disposal. “What we have seen this year is the use of more capital-efficient portfolios,” Veerman says.
Although higher interest rates are welcome, they could turn out to be a mixed blessing for defined benefit plan sponsors. Rising yields translate to lower bond prices, but for well-designed LDI programs that is the whole idea, as liability values would fall by a corresponding amount and leave the pension surplus unchanged.
“But if you tell me rates are going to be 150 basis points [bps] higher,” Eichhorn offers, “all those corporate bonds that have been issued in such abundance due to low interest rates … well, we would probably stop using the word ‘abundance.’”
Moreover, the coming changeover in Washington could sway the bond markets in several ways. Both President-elect Donald Trump and House Republicans have floated unorthodox proposals to eliminate the tax deduction that corporations have long enjoyed on interest expense. Plans for new laws have yet to crystallize, but, holding other factors equal, the loss of tax benefits on bond interest would raise the effective cost of borrowing and likely discourage new corporate debt issuance as well.
On the other hand, “The government deficit is large enough to supply new issues on the long end of the Treasury market,” says Eichhorn. Additionally, follow-through on the new administration’s proposals for a torrent of federal infrastructure spending would extend a steady supply for years to come.
He also points out the suggestion by Treasury Secretary nominee Steven Mnuchin to issue 50-year government bonds, whereas maturities are currently limited to 30 years. “A 50-year Treasury aligns well with pension liabilities,” Eichhorn notes.
“Plans wouldn’t have to worry about the long end of the curve when their liability stretches beyond the 30-year bond. [Fifty-year bonds] would be very welcome for pension investors, although there are a few hurdles we need to get over first.”
“LDI has many legs left,” observes Veerman. Pension risk transfers through annuity purchases draw much attention, and deservedly so, he says. “But the current pace of annuity deals is about $10 billion per year. Against a $3 trillion DB pension industry, that won’t scratch the surface.”
“And as pension plans get closer to 100% funding, sponsors will want to be hedged against interest rates,” Veerman adds.