Investing Strategies for Pensions in the Current Environment

As to why the funded status of the average U.S. corporate pension plan has fallen 5% year to date, there are three key lessons that pension plan sponsors should heed, said Gordon Readey, fixed income product strategist at BlackRock, speaking during a webinar on “Navigating a Low-Rate, High-Volatility Environment.”

“First of all, interest rates are difficult to predict and rates continue to disappoint,” Readey said. “Second, timely reporting of funded status is key. Third, even if you have the right reporting, you need the proper plan governance in place, be it a glide path or a frame of action. Plans that took these measures may have avoided the 5% decline.”

As to where the markets are now, we are seeing strong performance from fixed income and mediocre performance from equity assets, with 20-year-plus separate trading of registered interest and principal securities (STRIPS) up 22% year-to-date, long credit up 14%, long government up 13%, but the S&P 500 up a mere 3%, Readey said. “The flattening of the yield curve is critical to U.S. pension plans,” he said. “There have been record highs in duration and record lows in yield. This may call for rebalancing. While equity volatility has declined in the VIX Index, the MOVE Index is higher.” The VIX Index is the Chicago Board Options Exchange (CBOE) Volatility  Index, and the MOVE Index is the bond market’s equivalent of the VIX.

Therefore, pension plans should shift some of their assets to fixed income, said Stephan Bassas, head of Americas liability-driven investing at BlackRock. “Despite being historically low, U.S. fixed income yields are still attractive on a global basis, which is resulting in intensified international demand for U.S. fixed income assets,” Bassas said. “A high level of global liquidity supports demand for income, global excess reserves that can be estimated at up to $25 trillion.”

As a result of “U.S. fixed income valuations being at historical lows despite a resilient U.S. economy, hedging strategies are important,” he said. “The same goes for the corporate bond market. Foreign investors are primarily focused on investing in high-quality bonds, such as Treasuries and corporate bonds. However, the supply of long-dated corporate bonds has been reduced as a result of shrinking global M&A pipelines, putting narrowing pressure on spreads and curves.” This is a challenge for pension plans, since “long-dated corporate bonds are the backbone of pensions—but are facing a deficit of $43 billion year-to-date compared to 2015.”

To counter this, pension plans need to adopt “spread acquisition strategies,” Bassas said. “Hedge against tail risk. You are seeing more acceptance of lower yields, which means insurance for higher yields is getting cheaper, resulting in attractive strategies.” In addition, “inflation-protected bonds are starting to make sense for pension plans.”

NEXT: Strategic actionsGary Veerman, head of liability-driven investing at BlackRock Solutions, then set forth three strategic actions that the firm is currently recommending to its plan sponsor clients. First, Veerman said, “Understand your plan’s surplus risk level and underlying factor composition. Equity risk is compensated via the equity risk premium. On the other hand, nominal interest rate risk is arguably uncompensated relative to liability growth. Therefore, balance your risk budget toward markets that compensate investors.”

Second, use “capital efficient hedging instruments such as 20-plus-years Treasury STRIPS or similar capital efficient tools to replace market or long Treasury exposure,” he said. “STRIPS have twice the duration of long Treasuries and can deliver a higher hedge ratio.”

Third, “allocate more capital to long corporate bonds with or without increasing current exposure to interest rates. For those plan sponsors who are hesitant to move long because of low interest rates, an alternative approach is a custom long credit strategy where the plan sponsor acquires long corporate bonds, removing mortgages and high yield bonds, which are not appropriate hedging tools.”