The Covid-19 crisis presents an extraordinary time, proffering up a rare opportunity to refurbish and enhance a current fixed income allocation.
A Closer Look at Funded Status through Recent Volatility
Amid the global rout in equity markets, all else equal, aggregate corporate pension funded ratios may move closer towards 75% as of March month-end (from 82% in February). This has only happened 12 times since 2006, and the most recent occurrence was in 2012. In the table below we highlight six hypothetical pension plans at various levels of funded status and asset mixes to show how each has fared through recent market volatility.
As of March 23, 2020. Source: Voya Investment Management, Bloomberg Barclays and Standard & Poors. For illustrative purposes only.
Buy the Dip? Avoid the Mistakes of the Prior Decade
Following the 2008 crisis, many plan sponsors, assuming interest rates would rise, maintained their equity exposures in an attempt to earn their way out of low funded status levels. Instead, rates dropped 300 basis points and liability growth, on average, outpaced stock returns despite one of the greatest equity bull markets in history and the billions of dollars in contributions that sponsors poured into their plans over the last decade.
Pension plans are not hedge funds. Their objective function (when sufficiently funded) should be geared towards solvency and liquidity—not return maximization. And their asset allocation strategy should be calibrated as such.
In the current environment, any rebalancing towards equities beyond current target asset allocation needs to be analyzed in the context of the sponsor’s risk appetite, a contribution strategy and the plan’s funded status.
Sponsors must honestly reflect on their risk appetite. Does a sponsor believe their pension plan to be an appropriate vehicle to express their equity view? Would they go so far as to issue debt to the capital markets to invest in the stock market? Their pension plan promise is a debt promise just the same. However, overfunded pension plans result in stranded assets, and when underfunded they incur PBGC premiums and contributions. Risk taking in this construct is woefully unrewarded.
Would a sponsor issue debt to the capital markets to invest in the stock market? Their pension plan promise is a debt promise just the same.
For a plan less than 70% funded, absent any forthcoming contributions, is it prudent for a sponsor to re-risk? For a closed, frozen plan with shorter duration, this is a risky bet with retirees’ money. We believe it is more prudent for these sponsors to incrementally contribute to the plan and de-risk.
At the other end of the spectrum, a well-funded plan (e.g., >90%, closed frozen), should not be tempted to re-risk but rather lock in their position, shift their asset allocation to a mostly duration matched and diversified fixed income portfolio and/or use derivatives to address the interest-rate risk.
Moreover, the Covid-19 crisis presents an extraordinary time, proffering up a rare opportunity to refurbish and enhance a current fixed income allocation. So rather than fixate on timing the dip for an asset deployment in equities, sponsors should go bargain hunting. With the help of investment advisors and LDI managers, sponsors can seize this opportunity to methodically comb through fixed income instruments for investment grade quality bonds that are least likely to default, and comport with the duration of their pension plan cash flows.
Asset Allocations, Market Correlations and Pension Investing
The correlation between safe havens such as treasuries and risk assets (e.g., equities, spread markets) is one of the most fundamental drivers behind asset allocation decisions for large institutional plans.
During this past month’s market selloff, there have been large moves in both directions for equities and rates. However, plans that used treasuries as an underlying portfolio hedge— appropriately sized—were able to withstand the deterioration in risk-seeking assets. For instance, a 60% equity and 40% treasury portfolio may be misleading as it pertains to allocation of risk. In reality, such a portfolio behaves as though it were 80% risk seeking assets and 20% safe haven assets when the risk component is decomposed. It can be even more lopsided if the equity component includes small cap or emerging market asset classes. This makes it all the more critical to ensure that the “hedge” components of the portfolio actually do their job and function as a shield during broad-based market selloffs. Either the treasury allocation should be augmented, or there should be a derivative overlay to generate the requisite duration via swaps and/or treasury futures.
As we emerge into the post COVID-19, Zero Interest Rate Policy world ahead, the efficacy of alternative instruments in pension portfolios will likely continue to grow.
At Voya, we have been advocating the use of alternative instruments like Private Placements, Commercial Mortgage Loans and Agency CMOs to compliment traditional de-risking instruments (i.e. treasuries and high-quality long corporate public bonds). As we emerge into the post COVID-19, Zero Interest Rate Policy world ahead, the efficacy of these alternative instruments in pension portfolios will likely continue to grow.
In short, this is not the time to be a hero. Re-risking with equities can be a perilous endeavor while high-quality, liability-compatible fixed income instruments are on sale and can enhance or expand upon any fixed income allocation, resulting in a robust liability hedging program. Rates are historically low but they can go lower. Interest rate risk will continue to be the dominating risk factor for a pension plan in a zero rate world and should be addressed head on.
Voya Investment Management has prepared this commentary for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forwardlooking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.
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