During a webcast hosted by PGIM Fixed Income, speakers from across the organization dove deep into the current risk sources and return opportunities the firm sees in the equity and fixed-income markets, using the analysis to argue in favor of defined benefit (DB) plans adopting liability-driven investing (LDI) strategies.
The speakers included Tom McCartan, vice president of liability-driven strategies; Robert Tipp, chief investment strategist and head of global bonds; and Richard Piccirillo, senior portfolio manager of multi-sector strategies. While the group did not predict a recession is imminent in the U.S., they shared some sophisticated analysis of interest rate trends that may give pension plan sponsors reason to stop and think about the amount of risk exposure their portfolio has.
According to the speakers, “adopting LDI” in basic terms means changing the investing objective from maximizing returns to instead focus on meeting a specific funding goal over a specific time period. Setting such guidelines can allow a pension plan sponsor to better tailor the risk exposure to avoid large losses. This safety may potentially come at the expense of missing some of the upside, but that is not really significant if the pension plan is remaining more stable and is able to smoothly and surely pay out the benefits owed to beneficiaries.
The speakers said LDI is growing even more important as pension plans broadly move into a phase where they are not growing but instead need to be focused on meeting their benefit obligations. They said that plan sponsors must acknowledge that, when there is eventually another downturn, it is going to be harder for market authorities and governments around the world to revive the economy. This is because of all the easing that has happened since the Great Recession.
The speakers said debt levels remain incredibly high around the world, and so there is very little room for governments to stimulate the global economy through some of the traditional means if/when the next recession occurs. They noted how the U.S. has started, for its part, to tighten its monetary policy in response to strong growth and record-low unemployment. They said this was one of the main drivers of the equity market volatility of 2018 and early 2019.
The PGIM Fixed Income team had a few practical recommendations for pension plan sponsors to consider when it comes to adopting LDI and “getting off the funded status rollercoaster.” These include raising the pension plan’s interest rate liability hedge ratio to help mitigate interest rate risk; reducing spread duration and/or risk asset exposure to help lower funded status drawdown risk; moving from a market benchmark to a liability cash flow benchmark to help manage credit migration risk; and treating risk allocations and interest rate hedge ratios as distinct decisions to help achieve a high interest rate hedge ratio with desired risk asset exposure. Such strategies can be complex to design and operate, the speakers admitted, and will likely require the engagement of a specialist consultant or investment provider.
Importantly, the speakers emphasized that the move to an LDI strategy is a serious decision requiring a diligent planning and execution process. They said plotting the rollercoaster exit strategy first requires that sponsors identify the primary risks to funded status. For most corporate defined benefit pension plans, they are declining long-term U.S. interest rates; tightening long-dated corporate spreads; credit migration in investment grade corporate bonds; and falling risk asset prices, principally in the U.S. and international equity markets.
The speakers concluded that pension plans have benefited from the rise in interest rates and strong equity markets following a long period of easy monetary policy and, more recently, the 2016 presidential election, fiscal stimulus and corporate tax reform. The said the fundamental question for pension plans to ask today is, “Should you stay on the funded status rollercoaster or move toward a recession-ready LDI strategy?”