DB Plan Sponsors Looking to New Vehicles for LDI Strategies

Diversification is a focus for fixed income investments, and experts shared thoughts about strategies during a roundtable event.

With the continued low interest rate environment and wide volatility in the stock market, defined benefit (DB) plan sponsors are trying to figure out how to invest to keep their liability-driven investing (LDI) strategies successful.

During Insight Investment’s expert roundtable, “A 2021 Roadmap for Institutional Investors,” Kevin McLaughlin, head of liability risk management, North America, noted that the goal of an LDI strategy is to have assets track liabilities, and, with so much uncertainty in the markets, DB plan sponsors are focused on funded status volatility.

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There is also a growing focus on liquidity, he said. Especially for frozen DB plans, there are more outflows than inflows. “Over the next 10 years, DB plans could see outflows between 50% to 80% of assets,” McLaughlin said. “In the public DB plan space, some of those numbers are even more stark.”

Alex Veroude, chief investment officer (CIO), North America, said investors are wondering whether the 10-year Treasury note will break the 1% mark since it’s close to doing so now. However, he said Insight Investment’s view is that the world is in a state of financial repression, so it thinks real yields will be low, zero or negative in 2021. “If inflation is high, we’ll see a negative rate situation,” Veroude said.

Shivin Kwatra, head of LDI portfolio management, North America, said it is tempting in the current rate environment to take off hedges in a portfolio, but DB plan sponsors are resisting the temptation, and Insight Investment agrees with that decision. “Hedges should be part of a plan’s risk management program. We are suggesting plans think about increasing hedges,” he said.

Kwatra said, currently, most fixed income investments are in government bonds and STRIPS [Separate Trading of Registered Interest and Principal of Securities], and some of that could be achieved more efficiently with overlays. For fixed income investments that are in corporate vehicles, he said, the big theme has been to diversify away from corporate allocation both in public and private markets for better protection diversification and yield.

“Should you take off hedges and hope interest rates rise, or should you the stay course and increase your hedge ratio?” McLaughlin queried. “We think that despite rates being low, plan sponsors should hedge liabilities. The more they can hedge, the more they can lock down investment goals they seek to achieve.” He added that many plan sponsors—both corporate and public—are in decumulation mode, so the second reason to focus on hedging is the need to build a buffer to shocks on funded status.

McLaughlin said there is more sensitivity to a fall in interest rates than a rise in interest rates. “If rates decline further, the value of liabilities will increase 20% to 40%, but if rates rise, plan sponsors will only see a decrease in liabilities of 12% to 14%,” he explained. With this in mind, plan sponsors might be thinking about the risk of regret if they hedge too soon and rates rise—they’ll feel they lost out. But, McLaughlin said, it is better to be cautious in case rates fall.

“We see more focus on trying to make fixed income do more work. Plan sponsors are also more cash-flow aware to be able to pay for benefits,” he said. “Better hedges can free up liquidity.” McLaughlin added that before plan sponsors make investment decisions, they should ask if they are in a position to take on more risk.

Veroude said there will be a continued search for yield in the government bond space, and investors will find more yield in emerging markets and currencies tied to that, not in traditional bonds.

If DB plans can replicate Treasuries and STRIPS synthetically to free up capital, that should be a strategy, McLaughlin said. He also recommended that plan sponsors have three to five years of planned liquidity on hand.

Search for Growth

Going into 2021, DB plan sponsors are also asking where to turn for growth. “They are wondering if a large allocation to fixed income is still the best thing,” Veroude said. “We expect, and have already started to see, a rotation of investments in portfolios out of lower yielding assets and into other areas. Different asset managers have different answers for the best place to find growth.”

Veroude said there are fixed income vehicles that can provide diversification, negative correlation and yield/growth. “The next best thing might not be one single investment, but one to protect and one for growth,” he said.

In fixed income, growth will come from vehicles that don’t have a high propensity for default, Veroude said. Otherwise, investors should go straight to equities. “It would be nice to find investment vehicles that are not super crowded, but that’s easier said than done,” he said. “Investors can find some that are not over-crowded, but those vehicles are not widely advertised.”

There are two areas Insight Investment favors in the current market crisis: securitized investments and those with a liquidity premium—for example, private assets, particularly with lower default risk. “We think investors will increasingly skew their portfolios toward those,” Veroude said. “I think in five or so years, we will see DB plans’ fixed income allocations more in illiquid assets and less in government bonds. Intellectually, moving assets into private investments makes sense.”

In the search for yield, as plans allocate more assets to higher yielding securities, they will have to take on more risk, McLaughlin noted. Plan sponsors should ask if they can do that in a way to hedge liabilities. In the past, U.S. Treasuries were a hedge against equity risk, but diversification from Treasuries is now a theme, he said.

An equity with downside protection is fixed income-like, McLaughlin said. The challenge is the cost, but he said a “tremendous amount of work has been done to provide downside protection more efficiently than in the past.” Veroude said this is why he likes convertible bonds; they offer the upside of equity but if things go wrong, there is still the floor of an outright bond on hand. “They are coming back in vogue; 2020 has been a record year for the issuance of convertible bonds,” he said.

McLaughlin noted that there is hope for additional funding relief for DB plans. The Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act, which passed through the House in May, if passed in its current form, would extend the amortization period plan sponsors have for covering funding deficits. “It would mean lots of corporate plans can extend the time horizon for closing their funding deficit, so they could take on less risk and wouldn’t have to re-risk into equities,” he said.

NAGDCA Expects Movement on Retirement Reform in 2021

Priorities of the National Association of Government Defined Contribution Administrators is in recently introduced legislation, including allowing 403(b) plans to invest in CITs.

During a webinar sponsored by the National Association of Government Defined Contribution Administrators (NAGDCA) on Wednesday, Paul Beddoe, head of U.S. government affairs at NAGDCA, said, “Retirement reform is bipartisan and right front and center.” He said the Retirement Security and Savings Act, proposed by Senators Rob Portman, R-Ohio, and Ben Cardin, D-Maryland, “should and will eventually be passed.”

Reagan Anderson, senior vice president, government affairs at Capital Group, said, “The thing to highlight is that Portman’s commitment to a bipartisan bill is genuine and important,” but that the margins between the Democrats and the Republicans in both the House of Representatives and the Senate “are so slim, it will be tough to get a vote.” That said, Anderson added that she believes the leadership of the Senate Finance Committee, whether that turns out to be Democrat or Republican, will realize that “retirement security is a kitchen table issue and that it is important to help people rebuild their savings once we get past the pandemic, so I believe the Senate Finance Committee chairman will let the Portman-Cardin bill lead the way.”

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Beddoe said all six of NAGDCA’s priorities are in the Portman-Cardin bill on the Senate side, and three on them are in the bill on the House side. Those objectives are, first, to expand 403(b) investment options to include collective investment trusts (CITs), and, next, to permit non-spousal beneficiaries to roll inherited individual retirement account (IRA) assets into defined contribution (DC) plans.

NAGDCA wants to eliminate the 457(b) “first day of the month” rule, Beddoe continued. The association also wants to permit participants with Roth accounts in DC plans to roll Roth IRA assets into these plans. NAGDCA also wants to exempt Roth contributions in DC plans from required minimum distribution (RMD) rules, Finally, the association wants to permit DC plan participants to make qualified charitable distributions (QCDs). The first, third and sixth priorities are in the House version of the bill, Beddoe said.

He agreed with Anderson that because of the nation being sharply split between Republican and Democrat objectives, “We are feeling pretty good about the commitment of our key champions—but it is not going to be smooth sailing, and it won’t just land on our laps. We are going to have to work for it.”

As far as how the pandemic has affected public sector defined benefit (DB) plans, Jeannine Raymond, director of federal relations at the National Association of State Retirement Administrators (NASRA), said that because most state and local plans had business continuity plans in place, “they were able to get monthly contributions out the door. And, thankfully, the markets recovered, so most plans are expected to have stable assets in 2020.”

Andy Blocker, head of U.S. government affairs at Invesco, said it remains to be seen how the Department of Labor (DOL) will handle retirement issues under the Biden administration. It depends on who President-elect Joe Biden selects for key positions at the DOL and what their priorities will be, he added.

He said he doesn’t expect the Securities and Exchange Commission (SEC) to rewrite Regulation Best Interest (Reg BI), but that the SEC could be more stringent about its enforcement.

As far as Biden’s proposal to replace tax deferrals on contributions to 401(k)s with tax credits, Blocker said “that would be a major sea change” to the way 401(k) plans have been managed since their inception. “It would cause confusion, and you would have to explain a whole new system to participants,” he said, adding that he hopes it doesn’t go into effect.

Anderson said she expects Biden will be a champion of environmental, social and governance (ESG) investing.

She said the trillions in monetary and fiscal support the federal government has pumped into the economy to fight the effects of the COVID-19 lockdowns should, and will, become a concern of lawmakers. “So far, we haven’t been worried about paying for anything, but that is going to have to change in a big way,” Anderson said. “The spending has not been checked at all. Industries like ours will have to pay the tab.”

Raymond said she fears that retirement plan tax breaks are likely to fall in legislators’ crosshairs as they turn their attention to raising revenue to offset the COVID-19-related spending. “They always look to retirement plan tax preferences when they look for revenue raisers, because that is where the money is,” Raymond said.

However, at least at the outset of the Biden presidency, Anderson said, “Our industry is not at the top of Biden’s list right now because there are so many pressing issues, with COVID-19 still a threat.”

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