Weighing Your De-Risking Options
A changing interest rate environment and funded status improvements mean that many pension plans have an opportunity to re-assess their de-risking toolkit and/or end-state approach. In this article, we review plans at three different stages, summarize typical goals, and provide suggestions on how to allocate or re-allocate in 2024.
Federal Reserve (Fed) policy is currently more restrictive than at any point over the past two decades. This policy has led to higher interest rates, which have reduced US Defined Benefit (DB) pension obligations (liability). As a consequence, funded statuses are generally healthier than they have been in many years, with Wolfe Research estimating US corporate pensions to be more than 100% funded1 in aggregate for the first time since 2007.
Looking ahead to 2024, we do not forecast the macro environment to be as favorable to pension funds as it has been recently. We anticipate approximately 150 basis points of rate cuts in 2024, likely to begin mid-spring, and a mild economic slowdown where we expect to see below-trend global growth. While recession is not our base case, we would not discount the possibility; we forecast a 25% chance of a US recession over an 18-month horizon. Should rates fall and equities decline, funded statuses would be negatively impacted through a combination of liabilities being discounted at a lower rate (making them larger), and lower capital balances in the asset portfolio. For example, a 100% funded plan with a 60/40 allocation could see its funded status fall below 90%2 if the above scenario comes to fruition.
In addition to market developments, the demographic landscape for pensions continues to evolve as plans mature and population shifts occur. According to the US Census Bureau, “In 2020, about 1 in 6 people in the United States were age 65 and over. In 1920, this proportion was less than 1 in 20.”* As the Baby Boomer population has entered retirement, defined benefit plans are expected to meet more payout obligations.
*Source: US Census Bureau, 2020 Census: 1 in 6 People in the United States Were 65 and Over, May 25, 2023.
This changing macroeconomic and demographic landscape is certainly important for pension plans to consider, especially as it impacts funded status and the de-risking journey for plan sponsors at three key stages.
- Well-Funded Open and/or Accruing Plan
GOALS: De-risking to reduce funded status downside, while seeking returns to help cover liability growth
CONSIDER: Low-volatility equities, long-duration fixed income (corporate credit, Treasuries), bond futures overlay
Open and/or accruing plans may be balancing the seemingly competing priorities of minimizing funded status volatility while still positioning the portfolio so that the plan may benefit from positive market developments. Though a well-funded plan typically has enough assets to cover current projected retirement benefits, asset returns are often needed to help cover the “hurdle rate” of liability growth (interest cost), benefit accruals (service cost), and/or ongoing expenses. Sponsors may consider de-risking the plan if they haven’t done so already to minimize the volatility of the plans funded status, particularly given the current fixed income rate environment. However, plans with high hurdle rates may not feel comfortable moving too far down the path of de-risking, even with an overfunded plan; we’ve encountered plan sponsors that aren’t comfortable significantly de-risking until they are 120-130% funded on an accounting basis (e.g., projected benefit obligation, or PBO). The decision on whether and/or how much to de-risk is highly differentiated.
There are a host of external sponsor considerations that will influence the decision of how far to de-risk an accruing plan. Plans that still need to generate material returns may consider opting for a “defensive growth” portfolio, using assets like low-volatility equities, multi-asset credit, or Quality factor strategies that may provide some stability during drawdowns. Low volatility allows for capital appreciation along with capital preservation (particularly relative to other equity investments in stressed markets), an ideal scenario for plans looking to protect assets while also allowing them to grow. Quality investments are characterized by companies with less leverage, steady earnings patterns, and strong balance sheets. The share price of these companies may be more resilient during periods of economic stress.
Plans more focused on protecting gains may wish to refine their liability-based portfolio through increasing the interest rate hedge ratio (i.e., the ratio between the portfolio duration and the liability duration). While the typical vehicles for increasing hedge ratio include long corporate bonds or Treasuries, plans with a high hurdle rate may wish to improve capital efficiency by extending duration through US Long Treasury STRIPS or by utilizing Treasury futures in order to reduce the amount of capital committed to the liability-based allocation. The long duration nature of these assets matches up well with the duration generated by the liability cash flows, and mitigates the interest rate risk of the overall funded status. In a liability-based portfolio, we generally suggest opting for indexed exposures within the US Treasury allocation (where active managers are more challenged generating alpha), and see some benefit from considering active long credit.
While not traditionally viewed as a liability-driven investment given their lower interest rate duration, multi-asset credit strategies can provide spread duration and issuer diversification and exposure to the higher-yielding short to intermediate part of the inverted yield curve. These strategies allocate to high yield, bank loans, emerging market debt and currencies, as well as investment-grade credit. For open/active plans seeking a higher hedge ratio, utilizing a bond futures overlay can free up capital that can be allocated to multi-asset credit, in addition to collateral requirements for the overlay. In order to offset some of the yield give-up and mismatch to the corporate bond discount rate from the overlay, allocating to multi-asset credit can provide additional spread duration and higher all-in yields above the liability discount rate. This type of barbell approach can also better align yield curve exposure (key rate duration) gaps we often see in the 2-year to 10-year part of the asset-liability curve.
Although an increased allocation to fixed income is often associated with “de-risking”, the fixed income landscape has materially changed since the Fed’s hiking cycle began. Fixed income now provides a level of yield that allows plans to continue growing their assets without having to rely so heavily on equities. In fact, as a high-return, lower-risk asset, fixed income provides more efficiency to strategic asset allocations. Fixed income is worthy of consideration, even for plans with limited de-risking appetite.
- Well-Funded Frozen Plan
GOALS: More precise liability matching, dynamic hedge ratio management, hibernation, end-state planning
CONSIDER: Long-duration beta exposure in credit and Treasuries, completion overlay, Systematic Active Fixed Income, offloading liabilities through Pension Risk Transfer
Sponsors with well-funded frozen plans have the opportunity to consider end-state planning –the decision of how best to manage the risk of the plan as it gets closer to an end state solution. While plans still seek a moderate level of returns above the ongoing liability growth (interest cost) plus expenses to maintain surplus, seeking higher-risk assets to further improve funding is less desirable. That’s because IRS rules can reduce the value of surplus return above the amount needed to maintain or terminate the plan. Thus there are two routes commonly considered by well-funded frozen plans – hibernation and Pension Risk Transfer (PRT).
A hibernation strategy takes advantage of the more stable liability profile of a frozen plan and should be centered around preserving the plan’s funded status through all market environments. In some cases, improving the plan’s funded status can be valuable; however, there is a risk of trapped surplus in the plan leading to an asymmetric risk/return profile and making it unrewarding for a well-funded frozen plan to maintain a high growth allocation. Sponsors of these plans generally prefer not to contribute additional assets given that no additional benefits are being accrued. Thus an ideal portfolio for this situation materially reduces interest rate risk and curve risk, while providing return sufficient to cover ongoing liability growth (interest cost) and expenses.
Hibernation portfolios will be unique for each plan, but our typical recommendation includes a small (0-15%) allocation to diversifying and/or defensive growth assets and multi-asset credit, combined with a dynamically managed long duration fixed income portfolio to mirror the liability risk profile. The baseline design for the fixed income allocation would include a duration-targeted blend of Treasuries and credit. Active managers may further improve returns by their ability to generate alpha and potentially diversify issuer-specific risk.
One area to be mindful of is credit quality. Many managers in the active long corporate space benchmark to the Bloomberg US Long Corporate Credit Index, which contained 45% BBB/Baa credit quality exposure as of the end of 2023.* In addition to the potential tracking error of active managers to the index, the embedded exposure to BBB/Baa credit can introduce additional surplus volatility, as well as downgrade and default risk, when compared to high quality (A or better).
*Source: Bloomberg as of December 31, 2023.
We believe an attractive complement to a long duration liability-driven investment (LDI) portfolio is in the systematic active credit market, which provides more stable tracking error while offering competitive alpha, and hence high information ratio. These strategies can be managed to higher-quality (A or better) benchmarks more aligned with liability discount rates. Credit risk, both sector and issuer/issue specific, is managed via systematic, quantitative signals and cost-efficient trading and rebalancing. Moreover, these types of strategies offer lower fees than traditional active mandates. The risk/return profile and overall credit risk profile of systematic active fixed income strategies can complement fundamentally driven credit strategies, particularly those benchmarked to a broad-based long corporate index
Another option for plans that are frozen and well-funded would be offloading (annuitizing) all or part of the liabilities to an insurance company through Pension Risk Transfer. The PRT market has been highly active for the last decade or so, leading to generally favorable pricing for plan sponsors. However, PRT is often more costly than a hibernation strategy (and can reduce some external benefits, such as the ability of the plan to provide a net P&L income if particularly well-funded). Plans interested in pursuing a PRT strategy may wish to partner with an expert Independent Fiduciary, who can help reduce the fiduciary risk inherent in such a transaction.
- Underfunded Plan
GOALS: Growth orientation to reduce deficit, while minimizing contribution volatility
CONSIDER: Global equities, EM debt, HY debt, LDI/OCIO, Strategic PRT
Underfunded plans typically aim to safeguard the assets currently in the plan (particularly if the plan is frozen), while also improving funded status through returns, if possible. Many plans in this situation employ a “glide path,” which provides a disciplined way for the plan to de-risk by transitioning growth-oriented assets to liability-based, according to a funded status trigger-based schedule. The growth-oriented allocation is often comprised of developed and emerging market equities, non-investment grade debt, and alternative or private market assets.
Presently, we see compelling value for corporate defined benefit plans to incorporate Emerging Market Debt (EMD) into their allocations. EMD offers higher yields and longer duration relative to US investment grade credit, potentially providing some additional funded status volatility reduction. Hard currency EMD is our preference at this time, as it is driven by US Treasuries along with EM spreads. At current levels, EM spreads are attractive and are likely to tighten further if the US. achieves a soft landing, which is our base case.
Pension risk transfer is often the least economically efficient approach for underfunded plans, due to the “opportunity cost” of locking in the underfunding (by requiring the sponsor to immediately fund any deficit) rather than allowing the portfolio time to grow out of its deficit. Nevertheless, there are situations where strategically targeted liability reduction strategies can be advantageous for closed or frozen plans (such as the opportunity to manipulate the PBGC Variable Rate Premium cap and/or offer lump sums to active participants). Additionally, there are some cases where the sponsor’s P&L or balance sheet can benefit significantly from removing the plan obligations, which may drive the strategic decision for undertaking a partial risk transfer.
The Bottom Line
Every corporate defined benefit plan has a set of unique goals and constraints. Whether a given plan is on a de-risking journey or merely seeking to preserve funded status, the good news is that the fixed income landscape looks more attractive than ever in its current state. For plans that are still underfunded, we see opportunity in higher yielding sectors, particularly given the level of short to intermediate rates. However, regardless of funded status, we believe that yield curve risk, spread risk and credit risk management with a more dynamic approach should play a more prominent role. All plans, regardless of the size of the allocation to liability-based assets, can benefit from further customization of their LDI solution for more precision in managing liability risk exposure, while also ensuring the portfolio keeps pace with plan obligations and inherent non-investment related costs and expenses. Pension Risk Transfer can be a valuable exercise in some situations. Whatever your preferred path, State Street Global Advisors is here to support you in achieving and best outcomes for your participants and beneficiaries.
State Street Global Advisors can help with constructing your Defined Benefit pension portfolios and make recommendations for enhancements. Reach out to our pension team learn more about how we can help.