Commentary: Corporate pension funds have come a long way: are they ready to reduce their risks?

The year was good for company pension funds. By our estimates, average funded ratios are at their highest level since the global financial crisis, driven by market movements and plan contributions, including those boosted by last month’s tax incentive deadline.

Today, after being on hiatus for a few years, many plan sponsors find themselves able to put risk mitigation theory into practice. As they do, here are three things they should be aware of:

1. There is no free meal when using an unfunded term.

Plan sponsors considering ways to get the most duration exposure for their extra dollar should understand the less obvious costs built into each alternative. For example, consider Treasury futures, standardized contracts that typically expire quarterly. A multitude of factors can affect their performance relative to the performance of cash treasury bills, including “rolling costs”. Investors typically roll over their contracts before the delivery month to avoid physical settlement risk and pay a premium to do so, the result of a supply/demand imbalance. In recent years, there has been significant demand for long futures positions from pension funds and insurance companies that have long-term liabilities to cover, but the number of natural short-term sellers unfunded is limited. It is up to arbitrageurs to bridge the gap, a process that is not without risk and can use scarce resources such as repo lines and balance sheet capacity. The compensation for arbitrageurs to use these resources is reflected in the costs of rolling, which can vary significantly over time, especially for plans seeking to roll large positions.

Other tools, such as interest rate swaps, also involve costs and risks that are not obvious at the outset and should be carefully assessed when developing a liability and risk hedging strategy. determining the extent to which unfunded duration will play a role. One alternative that plan sponsors should consider is Treasury STRIPS, as they can potentially provide a relatively simple, capital-efficient and cost-effective way to extend duration. Ultimately, the size of the capital allocation to the liability backing assets, the desired duration target, and the dollar value of the notional exposure are among the factors that will influence how a plan should build its strategy. cover.

2. Credit markets might not be as risky as they look

The share of BBB-rated bonds in the investment-grade corporate bond market has risen dramatically — to 48% of the Bloomberg Barclays US Corporate Bond Index in June 2018 from 33% a decade earlier — leading some to ask whether the market has become significantly more risky. We don’t think so, but we think it’s important that plans understand the drivers of this trend. For example, the lion’s share of the rise in BBB bonds came from the financial sector. After the global financial crisis, the credit ratings of many major banks were downgraded due to concerns about their capital markets operations and uncertainty about future government support. But since then we’ve seen evidence that the big banks, in general, have improved their credit profiles (e.g. strengthened capital buffers), and in fact we’d say that segment of the market has better credit fundamentals today than when they had higher ratings ten years ago.

Amid concerns over BBB bonds, some plan sponsors have considered using limited-quality benchmarks to limit credit risk in their portfolio liability hedge allocation. However, we believe that this approach could have unintended consequences. Namely, it would eliminate a significant portion of the market from the opportunity set, which could lead to greater issuer concentration, exposing a portfolio to greater idiosyncratic credit risk. Instead, we think plan sponsors could consider three ideas:

  • Build a diversified corporate credit portfolio, including BBBs, to potentially broaden the opportunity set and reduce issuer concentration.
  • Combine this diversified portfolio with US Treasuries to arrive at credit quality in line with the discount rate and to potentially improve liquidity.
  • Seek fundamental-driven approaches that aim to identify stable and improving credits while helping to mitigate the impact of negative credit events.

3. Derisking doesn’t just mean buying long bonds

Plan sponsors often ask what else they can do to help limit funded ratio risk without sacrificing too much potential for funded ratio growth. We believe this highlights a gap between the traditional equity and long bond components of a diet portfolio. The equity allocation aims to increase the funded ratio of the plan, but at the same time subjects it to downside risk if stocks perform poorly (especially if those negative stock returns are associated with lower rates). And the allocation to long bonds aims to stabilize the funding ratio but does not help it grow.

We believe there are investments that can help bridge this gap – forming part of the yield-seeking portfolio, but potentially playing a dual role in providing downside risk mitigation during times of funding ratio stress while participating in bull markets and contributing to funding ratio growth in better environments. The focus should be on strategies that can offer a combination of low equity beta and/or moderate interest rate sensitivity (duration). Examples include strategies focused on infrastructure investments, income-oriented equities, low-volatility equities, long/short equity investments, and fixed income credit sectors.

In our estimation, replacing traditional equity exposure with these types of strategies may have the same potential for reducing funding ratio volatility as reallocating some of the assets to longer-dated bonds, but with greater potential for improving funding status. This could be a standalone first step towards risk reduction or part of a larger strategy to pull multiple levers to reduce risk.