COVID-19 Pullback: Pension Questions & Considerations Part Two
Defined Benefit | Investment Manager Research | COVID-19 April 23, 2020
• The global outbreak of COVID-19 has led to significant declines in the majority of return-seeking asset classes year-to-date in 2020
• Liabilities and many liability-hedging assets such as long duration credit have also declined through the first quarter, primarily due to the widening of credit spreads to levels not seen since the 2008 Financial Crisis
• Funded statuses have likely declined year-to-date in 2020 coming off of a year in which many plans also lost ground on funded status due to falling interest rates and narrowing credit spreads
• With U.S. Treasury rates falling to historic lows, return-seeking assets falling materially and funded statuses likely lower, we will seek to help Plan Sponsors answer the following questions over the course of a series of white papers:
1. Where is my funded status today amidst current market volatility?
2. Did I make the right decision by adding liability-driven investments (LDI) to my portfolio, and with interest rates at all-time lows, does LDI still make sense?
3. Rebalancing and glidepath considerations: De-risk or re-risk, where do we go from here?
Did I make the right decision by adding LDI to my portfolio?
The short answer is generally yes, though the past few years have certainly been frustrating for pension plans in general due to the persistence of falling interest rates and subsequently increasing liability values. In 2018, liabilities were down, but assets were generally down more. In 2019, assets were up significantly and liabilities were as well. So far in 2020, assets, especially equities, have declined significantly, while liabilities are relatively unchanged through the end of March. With 2020 starting as another difficult period for funded status, it is important that Plan Sponsors who have added an LDI allocation maintain perspective that the key culprit for funded statuses staying stagnant or declining over the past few years has been the consistent decline in interest rates, not the addition of LDI. In fact, long duration bonds have not only been more accretive to funded status than shorter duration or return-seeking fixed income over the past 10 years, but have also outperformed most broad asset classes over that period as shown in Figure 1.
On an annualized basis, it has been better to be in LDI than shorter duration bonds, with long bonds beating their shorter duration counterparts by over four percent annually over the past 10-years. For Plan Sponsors who have been perpetually concerned about interest rates being “low” and worried about the timing of the decision to initiate an LDI allocation, history has shown that there have been very few times over the past 35 years when extending the duration of fixed income assets would have been a bad one. Figure 2 shows there are very few points in time since 1994 when it was a bad time to initiate an LDI strategy, helping to affirmatively answer the question on many Plan Sponsors’ minds, To Start or Not to Start LDI?
With interest rates at all-time lows, does LDI still make sense?
Rates are low, but what “rates” are we focusing on?
LDI can still make sense for both sponsors who have already adopted longer-duration strategies as well as sponsors who are considering moving to LDI now.
Yes, U.S. Treasury yields have fallen to all-time lows. While the Federal Reserve’s actions have anchored the front end of the yield curve to zero, market forces have caused yields at all other maturities to precipitously fall between 1.7 percent and 2.5 percent since the end of 2018 as seen in Figure 3. Given most traditional pension plans have durations extending past 10 years, we believe the front end of the curve should not be relied upon as an indicator of the overall rate environment by Plan Sponsors.
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