With the first half of 2022 in the rearview mirror, it’s worth reflecting on the impact of investment market performance on retirement plans, in particular for liability-driven investment (LDI) portfolios.

The first half of this year has certainly been one for the books. The equity market, sovereign and corporate bonds all saw some of their worst six months in history (Table 1). In light of the current market environment, we believe that forward-looking investors may also benefit from rethinking their current hedging strategies.

Market background and the impact on DB pension plan deficits

For a defined benefit (DB) pension plan, we estimate that this would have resulted in an overall negative return of around 10-20% for many plans. Although this is likely to be one of the worst periods on record for assets, ironically, for some plans, the funding position has never been better. This is because the value of their liabilities has decreased significantly due to the rise in corporate yields, which means that we expect the overall deficit to have reduced for many plans on both a statutory and buyout basis.

LDI strategies: When, what, and why?

LDI strategies first came onto the scene more than 15 years ago. They were designed to help address funding volatility for retirement plans. LDI strategies are predominantly investments in government and corporate bonds that ideally resemble the return of retirement fund liabilities.

To this point, LDI has worked well, limiting funding ratio volatility. Importantly, this strategy has also been a source of income generation.

In these past 15 years, LDI strategies have really only existed during bull bond markets, with interest rates falling over a long period of time. But where do LDI strategies stand today, in this unusually turbulent market amid rising interest rates?

Mechanically, these strategies have had a negative return. However, since hedger ratios largely remain under 100%, the net impact on funded status has been positive.

In this market environment, it’s easy to call just about any asset class into question:

• Equity markets are down significantly and retirement plans are rightly cautious about selling and missing a rebound.
  
  
• For the first time in years, investors may find corporate bonds attractive. Selling now would likely crystallize losses. Additionally, credit likely forms part of the endgame portfolio as it constitutes most insurers’ asset of choice for hedging retirement plan liabilities. Selling now would take a plan further from this long-term portfolio.
  
  
• It’s possible that some retirement plans might find themselves overweight to illiquid assets right now. By definition it’s difficult and possibly costly to sell such assets. Therefore, this isn’t likely to be a viable option.

If there is no appetite to sell assets, retirement plans run the risk of being unable to accommodate an increase in liability hedging that its higher funding ratio would imply. An even worse scenario would be the inability to maintain hedging targets if rates continue to rise, which goes against many plans’ objective of minimizing unrewarded interest rate risk.

Coming back to the introduction, many plans’ funding positions have actually improved over the past six months, which means reducing growth assets may be an option. This is where taking a more holistic view of retirement plans’ positioning can help the decision-making process compared with narrowly assessing the pros and cons of each fund or strategy within a portfolio

A clear de-risking plan with appropriate delegation

Given the current market volatility, many plan sponsors have undertaken a de-risking journey (based on funding levels). A smooth transition to a low-risk portfolio frees up additional cash required to support the LDI portfolio through rising rates.

On the flipside, plan sponsors that have decided to keep control of the overall strategy have experienced governance bottleneck issues, which has prevented them from being reactive.

Reconfiguring amid rising rates

For years, interest rates have been low and DB plan sponsors have structured their plans accordingly. Because most plans target a modest hedge ratio, even with recent market turbulence, plans have broadly experienced an increase in funded ratios thanks to rising interest rates. In fact, according to the Milliman 100 Pension Funding Index, as of May 2022, funded ratios are at their highest levels since 2000.

But despite these strong funded ratios, some investors have been reluctant to bring their hedge ratios up to 90-100% because they’ve been concerned about rising rates. We see rising rates as a reason to consider upping hedge ratios. Interest rates have risen sharply in recent months. The FTSE Pension Liability Index has jumped 175 basis points since December of last year. It’s now at its highest level since 2013. From this high point, the likelihood of rates rising higher isn’t as strong as it’s been the past few years.

So it may be high time to enter into the fixed income or leverage exposure necessary to bring hedge ratios near 100%. Leverage can be an efficient means of minimizing both interest-rate risk and yield-curve risk. When used effectively, it can be a valuable component of an investment strategy aimed at maintaining a strong funded ratio.

To the extent that the reluctance in using leverage or pursuing a higher hedging ratio stemmed from a view on rates rising, now may be the perfect time to revisit a decision to be underhedged.

Conclusion

Risk management within LDI is well established and has again proved its worth through the last six months. But what’s been lacking in some cases is the holistic view of the overall strategy versus the plan’s ultimate goals. It’s all connected and plan sponsors need a strong governance framework to ensure optimal decision making across a portfolio, including when it comes to LDI.

Enhancing the governance framework through increased delegation, whether via a fiduciary arrangement or enhanced service from the asset manager, together with a clear de-risking framework can help ensure that investment solutions remain aligned with trustees’ overall plan objectives, even during volatile market conditions.

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IMPORTANT INFORMATION

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Diversification does not ensure a profit or protect against a loss in a declining market.