Investing January 26, 2021

Creating an Effective LDI Strategy for 2021

Defined benefit plan sponsors need to look at different tools for making their liability-driven investing strategies more efficient, and they should re-evaluate their glide path triggers.
Reported by
Art by Sarah Mazzetti

The volatile equity market, an expectation of lower future returns and the low interest rate environment have led many financial professionals to suggest the traditional 60/40 portfolio is no longer effective for retirement plans.

With their minds on improving the funded status of their plans, many defined benefit (DB) plan sponsors take the traditional 60/40 portfolio a step further and use liability-driven investing (LDI) strategies. Considering those market factors, are traditional LDI strategies no longer effective?

Never miss a story — sign up for PLANSPONSOR newsletters to keep up on the latest retirement plan benefits news.

Michael Clark, managing director and consulting actuary with River and Mercantile, says last year was an interesting year in terms of what it showed about what DB plan sponsors do with LDI glide paths in volatile markets.

“Most plans probably ended the year where they started [in terms of funded status], but there were a lot of ups and down in between. Those that rode the course probably ended the year slightly worse off,” he says. “After the market crash in the first quarter, those that put more money into growth assets probably are a little ahead of those that stuck with the status quo.”

Most DB plan sponsors are looking for a portfolio strategy that prevents them from going backward in funded status, Clark says. There is a trade-off between liability hedging and seeking returns. “Plan sponsors need an understanding of what risks they are taking on and where and how that should change over time to get them to where they want to be,” he says.

The broad thesis is that DB plan sponsors do need to think about restructuring their LDI portfolios, says Kevin McLaughlin, head of liability risk management, North America, at Insight Investment. He says plan sponsors should focus on two things: increasing the hedge ratio due to extreme volatility to make sure they have enough liquidity, and increasing returns to fill funding gaps.

More than ever, plan sponsors need a hedge for liabilities, McLaughlin says. “If they don’t hedge for interest rates and get it wrong, even small movements in interest rates will mean the return needed from growth assets will increase exponentially,” he explains. “Plan sponsors need to do more hedging now than in the past, particularly if they are underfunded.”

McLaughlin adds that plan sponsors need to hedge to control volatility. “We advise clients to try to keep problems solvable through investment returns. If interest rates decline, they will need assets to fill the funding gap,” he says. “The reason we think underfunded plans need hedging is we’re not sure we’ve seen the bottom for interest rates and there is so much market volatility.”

Components of an LDI Portfolio

Going beyond the traditional glide path, Clark suggests DB plans can use derivatives to decouple risk from growth. A derivative is a security with a price that is dependent on or derived from one or more underlying assets, according to Investopedia. Underlying assets could be stocks, bonds, commodities, currencies, interest rates or market indexes. The derivative is a contract between two or more parties based on the underlying assets, and its value is determined by fluctuations in the underlying assets. Futures, swaps and options are types of derivatives.

“With derivatives, plan sponsors can decide how much interest rate risk to take on or hedge and how much market risk to take on or not, and they can do that in a very controlled way,” Clark says. One way to do that with derivatives is by taking the assets in the portfolio and investing all of them in liability-matching vehicles, then accessing equity synthetically through puts, calls and options strategies to give equity a value the plan sponsor is comfortable with, he explains.

“This offers an optimized interest rate hedge and an equity exposure plan sponsors are comfortable with,” Clark says. “Sponsors get some downside protection, a range of returns they like and a bigger engine than what they have with just the physical assets in the portfolio.”

Clark says derivatives swap options (also known as swaptions) should be considered for the liability-matching side of LDI portfolios. “We’ve been talking to clients about the potential for interest rates to go up and liabilities to go down, but they don’t necessarily want to lock into a strategy,” he says. “This is where derivatives swaptions can be adjusted to protect the plan when rates fall.”

According to the Corporate Finance Institute, a swaption is an option contract that grants its holder the right, but not the obligation, to enter into a predetermined swap contract. In return for the right, the holder of the swaption must pay a premium to the issuer of the contract. Swaptions typically provide the rights to enter into interest rate swaps, but swaptions with other types of swaps can also be created.

“When you look at pension plan risk management in general, most DB plan portfolios have liability-matching and return-seeking assets, and they use funded status triggers to make portfolio changes. We’ve seen that’s effective to a point,” Clark says. “But for plan sponsors that want to make a meaningful difference in closing their funding gap, they need to look at different tools. Derivatives present good opportunities, especially in volatile markets like we’ve seen in the last 12 months.”

McLaughlin also points out that many plans are cash flow negative—paying more in outflows than they get in inflows. For this reason, they want to avoid a large shock to assets, especially large declines or drawdowns. “There’s a lot of focus now on the equity downside,” he says. “We see more focus on low volatility equities or volatility-control type strategies. There is much more interest in downside equity protection; there’s been a move from diversification to downside protection.”

For the growth part of an LDI portfolio, being well-diversified is still important, Clark says. “We saw quite a bit of disparity in asset classes in 2020,” he says. “Plan sponsors should understand what asset classes are available to them to create a well-diversified portfolio, and rebalancing is a tried and true principal.”

On the fixed income side of an LDI portfolio, there’s been interest in how to increase returns from fixed income assets, McLaughlin says. “We’ve seen more interest in private markets and illiquid securities such as structured credit and private loans,” he says. “The challenge is that more illiquid assets could potentially mean not enough liquidity to pay for outflows, which would make DB plan sponsors become forced sellers of equities. So they need to be careful when changing portfolio components on the fixed income side.”

McLaughlin says he has seen plan sponsors solve this conundrum by having more liquidity on the equity side of the LDI portfolio. Plan sponsors may do so synthetically via equity futures or equity return swaps.

“We would say two things: When hedging DB plan portfolios, be as capital efficient as you can to free up assets to pay benefits or buy private credit, and protect against large drawdowns in equity by having a strong hedge ratio to protect from volatility,” McLaughlin says.

Rethinking Glide Path Triggers

McLaughlin suggests DB plan sponsors should rethink their LDI portfolio glide path triggers. “Many [plan sponsors] are in a situation where they are a long way from the next glide path trigger on a funded status basis or on a market level basis—for example, a trigger of a 3% market rate on Treasurys,” he says. “A big focus in 2021 will be reassessing glide path triggers to make sure they are realistic.”

McLaughlin says Insight Investment’s broad advice would be for plan sponsors to have both a funded level trigger and an interest rate trigger. “Plan sponsors have to consider what could happen if equity markets decline and funded status declines. It’s better to have a combination of triggers so as not to miss hedging opportunities,” he says.

Interest rate triggers will signal a path for hedging, McLaughlin explains. “If interest rates go up by a certain amount of basis points, the plan sponsors can do more hedging,” he says. “If the interest rate trigger is less static and more dynamic—if plan sponsors think interest rates are range bound—there is more flexibility. Plan sponsors can take hedges off and on.” McLaughlin says he’s seen this strategy used a lot in the UK and he believes U.S. plan sponsors can take advantage of it.

Plan sponsors that adjusted their portfolios when they hit a funded-status trigger but fell below it due to a market downfall last year should look to their investment policy statement (IPS) for what to do, Clark says. It might require them to re-risk their portfolios. “Many who did that in the first quarter of 2020 came out ahead by the end of the year,” he says.

Clark says River and Mercantile would advise that, in light of 2020, which showed that market movements can happen quickly, plan sponsors should look at their governance structure. “If the IPS and governance structure don’t allow [plan sponsors] to take advantage of market movements quickly, they will miss out on market opportunities,” he says. “Having good consultants watching for opportunities and bringing ideas to the table while being able to act quickly will be key to making progress on funded status.”

Compliance January 25, 2021

Avoiding Retirement Plan Operational Errors

Understanding the plan document, establishing a plan administrative policy, having good service providers and doing regular checks can help plan sponsors avoid operational errors.
Reported by

Plan sponsors that avoid errors in plan operation will experience fewer administrative headaches, as well as regulator enforcement and potential penalties.

Rachel Smith, a partner in law firm Goodwin’s ERISA [Employee Retirement Income Security Act] and executive compensation practice, says plan sponsors should take plan administration seriously. “There comes a point where plan sponsors should realize they have to step up their administration game. The plan won’t run itself,” she says.

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

Smith adds that plan sponsors should take their delegation responsibility seriously. “Make sure someone is the point person,” she says. “Not every company has the financial resources to have a full-time staff member devoted to the retirement plan, but plan sponsors have a fiduciary responsibility, an operational responsibility, a responsibility to employees. They should make sure someone who knows what they are doing is administering the plan.”

To administer the retirement plan correctly, it’s important to know what the plan document says, Smith notes. “The vast majority of issues I come across happen because the administrator didn’t understand the plan provisions,” she says. “A common example is the definition of compensation [in the plan document]. The administrator must know this to make sure payroll is coded correctly and that payroll is transferring the correct data to the plan’s recordkeeper about the type of compensation and when it was paid. Bonuses, commissions and equity payments can trip things up.”

Smith says plan eligibility and entry dates are other areas where she sees mistakes being made. “Not understanding what the plan document says about whether participants can enter the plan immediately or whether they have a waiting period can create major headaches down the road,” she says.

Administrative Policies

Leisha Gosling, new business consultant at Retirement Management Services LLC (RMS), says she believes plan sponsors should have a written administrative policy, and much of that policy will be dictated by the plan document.

The administrative policy will tell who is responsible for what, including whether the plan sponsor or a certain vendor is responsible for administrative-related services. The policy should state who is going to monitor the plan to make sure procedures are done correctly. “For example, will the plan sponsor or the payroll vendor check to make sure deferrals are deposited on time?” she queries.

“Once that is all defined and everyone knows who is going to do what, there should not be any surprises operationally,” Gosling says.

Each plan is different and uses different providers—for example, some plan sponsors bundle services with one provider and others don’t—so the administrative policy will be tailored to each plan, Gosling says. The policy is also shaped by what the plan document says.

“The policy will be based on what the document states, but plan sponsors might have some flexibility for certain procedures,” Gosling explains. “For example, if the document does not specify when participants can make changes to their elective deferrals, plan sponsors can specify that in the administrative policy. However, if the plan document specifies a procedure, the administrative policy has to match what the document says.”

Since the administrative policy is tied to what the plan document says, it should be updated when a plan amendment is implemented. But Gosling says it is also best practice to review the policy if there is a provider change or a tax law change and, in general, once every three years or so.

Provider Selection and Monitoring

Plan sponsors should make sure they have a team of outside providers they can depend on, Smith says. “Make sure providers have knowledgeable people internally to monitor the plan,” she says. “Plan sponsors should also have a good relationship with the recordkeeper where it is easy to get on the phone and track plan terms and get questions answered as they arise.”

Joel Mee, senior director of retirement plan sales at The Standard, says one of the most obvious things plan sponsors can do to avoid operational errors is make sure there is data integration between the payroll provider and the plan recordkeeper. “There should be a direct transfer to the recordkeeper of participant census data and financial information such as compensation, contribution amounts and loan repayments,” he says. “And, 360 data integration would include transferring data from the recordkeeper back to the payroll provider, for example, when a participant changes his deferral rate. This removes the human element, for the most part, so there is less chance of error.”

Mee says he believes plan sponsors should partner with a provider whose services are powered by rigorous data technology. Plan sponsors should ask what providers are doing to verify the accuracy of data and how often they review participant data for discrepancies. “Historically, recordkeepers or third-party administrators [TPAs] would look at data once a year when they perform nondiscrimination testing or fill out the plan’s Form 5500. But now, providers have tech or processes, or both, in place to verify the accuracy of the payroll file while it’s being submitted and to raise a red flag when an issue occurs,” he says.

Mee cites a common example of a loan repayment included in the payroll file when the participant has already paid off his loan. “If payroll doesn’t stop payment deductions when the loan is paid off, and it is not caught until a later date, it’s an administrative headache to get the money back out of the plan and to the participant,” he says. “A provider with technology that prevents money from coming into the plan when it doesn’t belong helps avoid operational errors.” Mee offers a similar example of a participant contribution transferred to the recordkeeper via the payroll file when the employee is not yet eligible to participate in the plan.

Mee says something surprisingly common that wreaks havoc—when there’s a dearth of good data technology—is the use of an Excel file to transfer payroll data. “Some plan sponsors still extract data from the payroll provider and manipulate the data on an Excel sheet before sending it to the recordkeeper,” he says. “If the plan sponsor inadvertently shifts data down a row, everyone would have the wrong address, contribution amount, etc. This is very tenuous to clean up, so recordkeepers should validate data with each payroll file.”

In a blog post on RMS’ website, Gosling say an administrative policy should not only define the roles of those responsible for the plan’s administration and related services, but it should also establish provider selection procedures and criteria, provider monitoring procedures, and procedures for replacing service providers that fail to satisfy established objectives.

It’s a fiduciary duty to monitor retirement plan providers, so Gosling says plan sponsors should make sure vendors are doing everything that was promised. “And, if the administrative policy says the payroll provider will send information to the recordkeeper within a certain time period, make sure it is doing so,” she adds. “Make sure, if a participant changes his deferral online, it is being changed timely on payroll. Some plan sponsors think that by hiring a provider they don’t have to do these things, but they need to stay on top of it.”

Smith adds that large-size plans often also engage fiduciary investment advisers or managers. “Plan sponsors should understand what that person does or doesn’t do,” she says.

Plans that have more than 100 participants should also make sure they have an accounting firm they can rely on for financial audits, Smith says. “The key is going with someone who is primarily tasked with ERISA plan audits,” she states. “It’s not uncommon for some smaller firms to pivot to retirement plan audits in the summer as a seasonal practice, but we like to see clients work with auditors that specialize in ERISA audits, not dabble in it.”

Smith adds that the more auditors know about retirement plans, the more they’ll be able to catch things. “We see operational errors come to light in audits every year,” she says. “It’s the first or second most common way issues get caught—maybe behind a recordkeeper conversion.”

“Hiring providers that know what they’re doing, provide good service and do what they say they will do, that will stop operational errors,” Gosling says.

Plan Sponsor Checks

However, plan sponsors shouldn’t wait for something to be caught on a plan audit, Smith points out. They should do checks throughout the year.

“Plan sponsors often think that with providers in place, they won’t have to worry about operations anymore, but that’s not true,” she says. “No one knows plan operations better than the plan sponsor. Just relying on samples the auditor will pull is insufficient. We like to have clients run spot checks and have processes in place for internal operational audits.”

Similarly, Mee says plan sponsors should not just delegate information validation to their providers, they should do a spot check or audit themselves. He suggests doing so every payroll period but, at the least, he says, plan sponsors should do this periodically.

Mee says great retirement plan administration is all about good data going in and good data coming out. “The source of data is usually that payroll file,” he says. “Plan sponsors should make sure there is a process to get accurate and complete payroll data to plan providers and that providers have technology or processes in place to validate the data.”

Smith says checklists and fix-it guides on the IRS website can be useful. “I really like the IRS’ and DOL’s plan sponsor resources,” she says. “They’ve made a good effort at distilling the rules and giving plan sponsors the opportunity to learn about retirement plans and what they should be doing.”

Plan sponsors should have a good ERISA attorney available when questions come up, Smith suggests. “They won’t talk to the attorney all the time, but having someone to call when more technical issues come to light is important,” she says.

«