As corporate defined benefit (DB) plans consider market volatility, interest rate movements and cash flow needs, there are certain investments and strategies that investment managers suggest they consider.
Adam Levine, investment director of abrdn’s Client Solutions Group in New York City, says funded ratios for corporate DB plans improved quite a bit in 2021 both because of returns and discount rate movements, so more plans are moving into fixed income to protect their funded statuses. Closed or frozen plans, especially, are locking in funded ratios.
“We believe there are several considerations for plan sponsors when moving to fixed income,” Levine says. “They need a diversified mix of fixed income. Many plans are invested in long-duration bonds, but if the benchmark is the Barclays Long Credit Index, they might be adding more companies they already own. So clients are concerned with concentration issues.”
Levine says DB plan portfolios need to consider a number of different fixed-income options. “We’re talking to clients about muni [i.e., municipal] bonds, crossover bonds and sectors such as utilities,” he says. “It’s about making sure portfolios are not overly concentrated in one index or in the same companies.”
DB plan sponsors also need to be aware of a curve risk—i.e., a risk that while interest rates might not move a lot, the shape of the interest rate curve might change, Levine adds. It could be that DB plans’ assets have a combination of very long and very short durations, and a change in interest rates might happen in the middle of the curve, so plan sponsors could see liabilities move while assets don’t, he explains. Plan sponsors should match their assets to the interest rate curve.
Levine also suggests DB plan sponsors look at the timing of cash flows needed and make sure fixed-income durations are lined up to meet benefit obligations.
Managing Equity Risk
For now, equity risk is less significant than in the past and interest rate risk is ideally less impactful as well for DB plans, according to Levine. That said, many plan sponsors are trying to reduce risk.
“We think having an equity risk mitigation strategy is prudent for any plan sponsor that has a material allocation to equity,” Levine says. “We are seeing cyclically adjusted price-to-earnings [PE] ratios for companies are near all-time highs. A strategy where a DB plan portfolio is well-protected against a potential market correction is prudent. Sponsors need some type of hedge that rewards investors during a correction.”
Private markets have been touted as a good asset class for institutional investors over the past several years. But Levine says that while there are plenty of return opportunities in private markets, his guess is that corporate DB plans will not be moving to that asset class anytime soon.
“Private assets have illiquidity issues and plan sponsors are trying to reduce risk,” he explains. “Many plans are in wind-down mode, so locking assets in illiquid investments is not a strategic move.”
Mike Hunstad, Northern Trust Asset Management (NTAM)’s head of quantitative strategies, based in Chicago, says private market investments are a diversifier with potentially lower volatility, but the “reality is you should never put 100% in private markets. DB plans will almost always have public market exposure.”
However, Levine says, there are opportunities for DB plans in infrastructure investments. He is advising plans to invest in infrastructure to help provide downside protection through diversification.
“Infrastructure is important as a strong potential hedge against inflation because lot of revenue streams can be directly tied to inflation,” Levine says. “I think it can be a diversifying equity investment. Historically, the combination of listed and unlisted infrastructure can be a diversifier to equity portfolios.”
“Infrastructure is a promising investment class, in our view,” Hunstad adds. “It’s a good inflation hedge, but plan sponsors have to consider total volatility.”
In addition, small-cap equities are expected to outperform with active management. “The PE ratio of small-cap companies relative to large-cap companies is near the lowest it’s ever been. Small-caps are trading near their largest discount in 20 years,” Levine says. “Smaller-cap companies materially outperformed large-caps in early 2001—the last time we saw anything close to this ratio—and when that happened last time there was strong outperformance.”
Hunstad says the best investment opportunities for corporate DB plans will depend somewhat on their liability profiles. But a consistent theme is that plans are looking to de-risk. “Low interest rates and the expectations the Fed will increase interest rates, as well as heightened equity market volatility, are driving this,” he says.
“If plan sponsors expect more volatility in the future, it makes sense to lower volatility, so while plan sponsors are maintaining or increasing equity exposure, they are looking to lower volatility,” Hunstad continues. “Plan sponsors are using strategies of higher-quality stocks with a lower-volatility profile. This includes investments with lower fundamental variability, meaning a good cross section of stocks where earnings are relatively stable. Our lower-volatility strategy lowers volatility by 20% to 30%.”
Advantages of Factor Investing
Hunstad sees advantages in factor investing, which is an approach that targets specific drivers of return across asset classes. He says NTAM’s DB plan clients are the biggest users of factor investing. “When thinking of total risk profile and the liquidity issue, lower-volatility factor strategies are great tools to manage liquidity while also lowering risk,” he says.
Other advantages of factor investing, according to Hunstad, include that:
- Factors are a persistent source of excess return. Academic studies have repeatedly shown that over the past 50 years, factor exposures are the primary source of excess return among successful active managers.
- Factors are granular and capture specific behaviors in the equity market—i.e., they can be used as building blocks to craft many different types of equity outcomes: lower volatility, lower beta, higher income, etc.
- Factors are scalable. In other words, sponsors don’t have to worry about exhausting alpha potential like they do with traditional fundamental active managers.
- Factor exposure is relatively cheap. Compared with traditional active management, factor exposures are a bargain.
- Factors pair well with environmental, social and governance (ESG) investing. Both tend to rely on quantitative scoring methodologies, so it is relatively easy and cost-effective to integrate ESG and carbon considerations in a quantitative factor portfolio.
“When we construct portfolios for DB plans, quality and low volatility are factors they are moving to,” Hunstad says.
For DB plans that are liability-driven investors, any surplus should be as return-generating as possible, he notes.
“If you’re trying to reduce the contribution the sponsor has to make every year, you need any surplus to be earning as much as possible,” he says. “You need to not only generate higher returns, but make sure there is relative stability in the portfolio.”
Hunstad says private investments are potentially good for surplus investing, but plan sponsors need to be cognizant of their illiquidity risk. Public equities that are higher quality and lower volatility make sense for surplus investing.
He notes that some DB funds are moving away from growth to value as a factor. This also tends to provide some downside protection.
“A lot of our clients are looking at the growth side of the equity market and seeing the multiples they are paying are at historic highs relative to value investments,” he says. “They also see in cap-weighted benchmarks, like the S&P 500, where growth stocks have dominated, an increasing amount of concentration risk.”
With concentration risk, Hunstad says a hiccup with a single security could have an impact on the entire benchmark. For example, a year ago, Chinese ecommerce giant Alibaba was about 9% of the total market capitalization in the index in which it is included. Its decline has brought down the entire benchmark, so it could bring down the entire portfolio of DB plans, Hunstad explains.
“A lot of clients see that as a lot of risk, and one way to diversify is to move into the value direction,” he says. “It has helped in the past several months as the market has been volatile.”
Hunstad adds that plan sponsors that are considering Fed interest rate hikes should know that, historically, value stocks have fared better.