Advising Pensions and Endowments in Rocky Markets

From 100-year bonds to sophisticated hedging, the world of pension plan investing is different from the DC plan domain.

Art by Katherine Streeter

Given his role as head of client solutions and multi asset for Legal & General Investment Management America (LGIMA), Jodan Ledford spends more time thinking about pensions than defined contribution (DC) plans.

He says the conversation about retirement readiness in the U.S. tends to focus on DC plans, given their increasingly important role as a foundation of the private-sector retirement system. However, the U.S. pension plan market remains highly dynamic and represents a great opportunity set for expert financial advisers to apply their skills.

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In terms of the investment outlook pension plans face in an increasingly volatile, late-cycle market, LGIMA has advised institutional investors to come “closer to home on risk in the fixed-income portfolio, and to focus on identifying good value when it comes through the market.”

As an example, he points to the recent issuance by the University of Pennsylvania of a 100-year bond. Press reports indicate the University successfully priced $300 million in “century bonds” at a yield to maturity of 3.61%.

“There was tremendous demand for it,” Ledford says, citing institutional investors’ thirst for safe and stable assets paying returns above those of long-dated government treasuries.

Offering some perspective on the broader marketplace in which pension plans are operating, David Chapman, Ledford’s colleague and head of multi-asset portfolio management for LGIMA, says there has been a healthy amount of debate among his colleagues in terms of what the next five or 10 years may bring.

“I would say there is lots of debate and I would not say there is a lot of consensus, but this is purposeful because it allows us to deliberate and let the best ideas rise to the top,” Chapman says. “Generally, we do agree that we are in a late-cycle economy, but how to approach this and predicting exactly how the dominoes might fall and spark a recession—that’s where the real differences of opinion are focused.”

Chapman notes that, historically speaking, equity returns tend to be very strong in the year leading up to a recession—and his firm only projects about a 25% chance of a recession in its forecast for 2020.

“So, you can see how the returns given up by reducing your equity risk too early in this cycle—it can mean you effectively achieve the same result as suffering the losses incurred once markets start to decline, if you follow me,” Chapman says. “For pensions, navigating the volatility is about focusing on the level of risk you should take given your objectives and time-frame.”

According to Ledford, 2019 has seen “a decently robust demand” for liability driven investing (LDI) strategies for pensions and other institutional investors, including strategies that include some pretty sophisticated hedging techniques. The overall demand has diminished somewhat compared with 2018, but there has been a healthy flow into custom LDI strategies, Ledford says.

“For pension plans and other institutions, market volatility can be addressed through diversification and through hedging, and through really understanding what the investment goals are,” Chapman says. “As we look forward, it is a difficult market to project. Late-cycle markets tend to have more volatility, but that fact doesn’t mean that equity markets are going to correct a significant amount tomorrow, next week or next month.”

Chapman says investment managers generally are very conscious of the tough position the U.S. Federal Reserve is in.

“The flattening and inversion of the yield curve that has happened, it is a reflection of the inflation outlook and concerns about growth which come from being in the late cycle—as well as the political environment around tariffs,” Chapman adds. “There are challenges, but none of this goes to say that institutional investors should panic and do anything rash. It’s a great opportunity to reflect on how your risk budget is allocated. If the volatility in the last month has been hard to tolerate, that might mean that the objectives for your investments should be reconsidered.”

Like their DC plan counterparts, pension plans seem to be experiencing a new normal in terms of low interest rates. Pointing to a newly updated five-year capital markets assumptions report, Bob Browne, chief investment officer, Northern Trust, expects low-growth pressures will provide an inherent interest rate relief valve in the foreseeable future. He says President Donald Trump’s assertive attitude towards trade disputes has challenged the economy’s “Goldilocks” underpinnings.

“We believe global growth, while positive, will modestly disappoint investor expectations, and we are concentrating on ‘lower risk’ assets such as U.S. high yield and U.S. equities,” Browne says. “Political impacts on fundamentals will be partially diffused through continued low rates, enabled by ‘stuckflation’ and central banks, importantly the U.S. Federal reserve, begrudgingly accepting the bond market’s messages.”

As a result of these pressures, Northern Trust-managed portfolios are overweight interest-rate sensitive assets, such as global real estate and listed infrastructure.

When it comes to risk cases, Browne points first to “inflation tariff proliferation.” He explains that subdued inflation has been a key driver of favorable risk asset returns over the last few years. According to Northern Trust’s projections, an unexpected jump in cyclical inflation would put at risk the interest rate relief valve programmed into the base case above.

“While not ideal, the U.S—and, for the most part, the global—economy can withstand a concentrated trade war with China,” Browne concludes. “Risks arise if the United States (or others) meaningfully target other countries.”