COVID-19 Pullback: Pension Questions & Considerations Part Three
Defined Benefit | Investment Manager Research | COVID-19 May 19, 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?
Rates still seem low compared to long-term averages. Should I still consider LDI?
We would generally argue yes, though each plan has its own unique considerations. For those plans curious about LDI as it relates to the current market environment, we believe there are three primary reasons why longer duration bonds still make sense:
1. Pension outcomes are naturally asymmetric. On a relative basis, Plan Sponsors will feel more financial pain from downside scenarios than they will feel financial benefit from upside scenarios. For example, the less funded a pension becomes, the more it financially suffers due to higher variable-rate PBGC premiums, longer periods of time for which it will need to pay those premiums, higher minimum contributions and increased benefit restrictions. However, on the upside, once a plan is fully funded (100+ percent), the surplus of assets in excess of liability and termination costs must be taken back into corporate income (with a few exceptions) and is subject to an excise tax of up to 50 percent. To summarize, the net negative effect of dropping from 80 percent funded to 75 percent funded is more significant than the net positive effect of increasing from 115 percent funded to 120 percent; plan asset allocation should consider this asymmetric relationship.
2. The yield curve is now upwardly sloped, meaning investors are again being paid for taking duration risk. Additionally, the potential for a “lower for longer” scenario is much greater than it was just four months ago. History has shown that interest rates can remain low for extended periods. This could be particularly true for U.S. Treasuries and long duration U.S. corporate bonds given the high level of global demand for these assets currently, which can contribute to keeping their yields low. Barring the more unlikely scenario of interest rates rising both sharply and rapidly, Plan Sponsors who extend the duration of their fixed income allocation can enjoy the higher yields provided by the current upward-sloping yield curve which pays a premium for the additional duration risk. For example, as of April 15, 2020, the Barclays Long Government/Credit Index yields 2.4 percent while the shorter duration Barclays Aggregate Index yields only 1.4 percent. Therefore, while liability-driven investors get the benefit of better liability hedging from longer duration versus shorter duration bonds, they also receive a higher yield on those assets.
3. There is still downside risk at historically low interest rate levels due to the positive convexity of pension liabilities. Just like bonds, pension liabilities display convexity. Convexity is closely related to duration. While duration measures the sensitivity of the price/value of a bond/liability to changes in interest rates, convexity measures how that sensitivity changes as interest rates change. This is important in implementing a successful LDI strategy given that pension liabilities display positive convexity, which works against Plan Sponsors.
Figure 1 is a simplistic illustration of the effect of convexity on pension liabilities. At lower yields or interest rates, liability values increase at a faster rate (bad for funded status) while at higher levels of yields or interest rates, liability values decline at a slower rate. In addition, liability duration will increase (have greater sensitivity to interest rates) as discount rates fall, causing more volatility in funded status. This asymmetric relationship further illustrates the benefits of LDI, even at lower interest rate levels.
In Figure 2 we see a more real world example of these relationships via select historical data from the Barclays Long AA Credit Index. Prior to credit spreads widening and the discount rate increasing in late March, as rates fell, duration extended by 1.8 years and convexity increased. If we think of this index as a proxy for a pension liability, not only did the liability increase as rates fell, but its sensitivity to future rate changes (i.e. the convexity impact) also increased. Liabilities would now increase by an additional 1.8 percent versus the duration profile at end of 2018. In summary, there is still a significant benefit to hedge liabilities, even in a perceived lower rate environment.
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