Investing March 13, 2023

DB Summit: Long-Term Investing

Liability-driven investment, lump-sum distribution and de-risking options are all on the table, experts say.

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Given the volatile stock market and high interest rates, pension plan sponsors may want to consider custom, liability-driven investment strategies, according to a panel of experts.

Mike Gheen, a vice president and director of retirement plan services at Oswald Financial, told attendees of PLANSPONSOR’s DB Summit last week that investment managers need to create customized portfolios that match pension plan sponsors’ particular liabilities.

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While plan sponsors can buy “off-the-shelf products” like a long-term-bond mutual fund or an exchange-traded fund, Gheen said these may not necessarily match specific liabilities.

“You really need to be buying individual securities to maximize that matching potential,” Gheen said. 

Historically, if a plan sponsor did not have a plan that was worth more than $250 million, it was often stuck with off-the-shelf investment options. But Gheen said he has seen this dramatically change over the last few years, and customization now is available for plans all the way down to the $10 million mark.

Gheen recommended that investing in a combination of longer-duration bonds and equities is a viable strategy. If a pension is underfunded, Gheen said it is important to maintain a component of growth assets.

“No two plans are the same, so no two portfolios are going to look the same,” Gheen said.

For plan sponsors looking to terminate their pension plans, Kate Pizzi, partner in and senior consultant for Fiducient Advisors, said sooner may be better than later, because interest rates are high and liabilities are lower. The market is also expecting two or three more rate hikes from the Federal Reserve this year.  

Pizzi added that one of the “biggest nuances” in pension management right now is deciding when it is the right time to offer lump-sum distributions as part of a de-risking strategy on the liability side.

Pizzi said when offering participants a lump sum, the investment strategy needs to focus on what interest rate that payout is based on. Many calendar-year plans base a lump sum payment on a “look-back rate.”.

For instance, any lump sum that is payable in 2023 may be based on rates from late 2022, which could potentially be much higher than those at the time of payout.

In order for plan sponsors to understand and calculate their liabilities, Pizzi recommended that plan sponsors form a strong partnership with their actuaries, especially as interest rates continue to fluctuate.

Pizzi also said rising interest rates are surprisingly “good news” for pension investors because it has caused liabilities to shrink.

“For plans that are underfunded, that liability pie is bigger than the asset pie,” Pizzi said. “Having those dollars shrink more than the hit that the assets took actually has been a win for many plan sponsors.”

Although plan sponsors may worry about the falling stock market, Gheen said they are actually in a better place today than they were one year ago because of the rise in interest rates.

Gheen said many of his clients have seen the rise in interest rates as an opportunity to terminate their pension plans, since their liabilities are lower.

“A number of our clients that have been thinking about terminating the plan feel a sense of urgency,” Gheen said. “They don’t want to take a chance because if rates drop dramatically, they might not be able to terminate the plan.”

On both the asset and liability side, Pizzi said pension plan sponsors should take advantage of opportunities to “de-risk.”

Offering a lump-sum window or engaging in pension risk transfer activity are examples of ways plan sponsors can de-risk on the liability side. Pizzi says these strategies can lead to settlement accounting, which occurs when a significant percentage of liabilities is irrevocably transferred outside of the plan.

Gheen found that a lot of his clients have been shying away from including illiquid investments in their portfolios as they contemplate de-risking and are looking more into interval funds, which are liquid on a quarterly basis. He said his clients find interval funds as an attractive investment because they are looking to terminate their plans soon.

With the current volatile market, using an LDI structure is not a “set-it-and-forget-it,” according to Gheen, and it must be monitored on an ongoing basis, particularly for those sponsors that want to terminate the plan.

Investing March 13, 2023

Lower Liabilities Somewhat Offset by Equity Volatility in February

Overall, U.S. corporate pension funding levels experienced a slight increase last month.

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Corporate pension plan sponsors experienced slightly better pension funding levels in February, as falling stock markets offset the impact of higher interest rates, corporate pension funding improved marginally in February, according to analysis firms.

LGIM America’s February Pension Solutions Monitor, which estimates the health of a typical U.S. corporate defined benefit plan, found that pension funding ratios increased in February, and the average funding ratio is estimated to have increased to 99.9% from 99.8%.

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Global equities and the S&P 500 decreased 2.8% and 2.4%, respectively, according to LGIM. Plan discount rates, however, increased about 46 basis points over the month, with the Treasury bond component increasing 38 bps and the credit component widening eight bps.

Additionally, plan assets with a traditional “50/50” stock/bond asset allocation decreased 3.9%, while liabilities decreased by 4.1%, resulting in a 0.1% increase in funding ratios by the end of last month, the LGIM report showed.

LGIM concluded that the combination of weaker asset performance and falling liability values due to rising discount rates kept pension funding ratios relatively unchanged throughout the month.

Sweta Vaidya, the head of North American solution design at Insight Investment, said funded status overall improved by 1.4 percentage points, to 103.9% in February from 102.5% in January.

“The market is expecting two or three more rate hikes from the Fed this year, which may continue to decrease pension liabilities,” Vaidya said in a statement. “However, the question is: Will heightened equity volatility override liability gains and ultimately erode funded status? Do we want to wait and find out, ?”

Vaidya explains that if the discount rate were to increase 50 basis points this year, liabilities would go down and funded status would improve. However, if equities tank, this decrease in liabilities would not necessarily matter and funded status could drop. While year-to-date funded status is up slightly, Vaidya says the last few months have been quite volatile. In January, discount rates were down, which meant liabilities went up, but the equity market was strong enough that it overrode that rise in liabilities.

“You’ve got this push and pull between two sides of the balance sheet,” Vaidya says. “The Fed is controlling rates at this point, and the market is driving a lot of equity movements. … The way to protect yourself is to reduce the size of your equity exposure and to hedge your interest-rate risk.”

October Three reported that its traditional 60/40 portfolio lost 3% during February but remains up 3% for the year, while its bond-heavy conservative 20/80 portfolio also lost 3% last month and is now up 1% for the year.

Compared to January, February saw a reversal, according to October Three, as stocks were lower and interest rates were higher. The net effect was a modest boost in pension finances in the first two months of the year.

Discount rates moved 0.4% higher in February, according to October Three, and the firm predicts that most pension sponsors will use effective discount rates in the 4.9% to 5.2% range to measure pension liabilities right now.

Aon’s Pension Risk Tracker found that the aggregate funded ratio for U.S. pension plans in the S&P 500 increased to 95% from 93.6%. The funded status deficit decreased by $23 billion, which was driven by asset increases of $18 billion and liability decreases of $5 billion year-to-date.

The month-end 10-year Treasury rate increased 40 bps from the January month-end rate, and credit spreads narrowed by three bps. This combination resulted in an increase in the interest rates used to value pension liabilities, to 4.69% from 4.32%, according to Aon.

Michael Clark, the managing director of Agilis, said in a statement that two key events in February that shaped pension plan funded status.

“[First,] the Fed continued to raise the Fed Funds Rate but backed off from the larger increases from the prior 12 months and only raised the rate by 0.25%,” Clark said. “Even though there are signs that inflation growth is slowing, it still remains persistent and with a continued strong labor market the Fed is still looking to put the brakes on the economy. [Second,] towards the end of the month inflation numbers came in higher than expected. This sent markets downward as fears of a recession in 2023 still remain.”

According to the Agilis Pension Briefing for February, despite the poor investment returns from equity markets and rising fixed-income yield and spreads, pension plan sponsors most likely saw increases to funded status due to liabilities that declined more than investment portfolios.  

Wilshire Associates’ U.S. Corporate pension funded status estimated that the aggregate funded ratio increased by one percentage point, ending the month at 100.2%. Wilshire said the change in the ratio resulted from a 4.8% decrease in liability values, which was partially offset by a 3.9% decrease in asset values.

“February’s funded status increase was driven by the sharp increase in Treasury yields with the liability value experiencing its biggest monthly decline since September 2022,” stated Ned McGuire, managing director of Wilshire. “Overall, discount rates are estimated to have increased by over 30 basis points due to continued inflation worries.” 

McGuire added that February’s month-end funded ratio estimate of 100.2% indicates that U.S. corporate pension plans are fully funded in aggregate. This estimate is at its highest level since the end of 2007, which was estimated at 107.8%, before the Great Financial Crisis.

Milliman, in its latest Milliman 100 Pension Funding Index, found that ratios rose to 111.6% in February from 109.6% in January, and the funded status surplus increased to $154 billion.

While the market value of assets fell by $40 billion as a result of February’s 2.23% investment loss, Milliman concluded that pension liabilities decreased by $62 billion to $1.325 trillion at the end of the month. This change is the result of a 39-bps increase in the monthly discount rate, to 5.24% in February from 4.85% in January.

Milliman reported that discount rates have yoyoed in the first two months of 2023 and are up just 2 bps in aggregate since the beginning of the year.

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