Article May 26, 2022

Managing your pension LDI strategy through a down market: Don’t let your strategy blow up

Written by
Share

Print Friendly, PDF & Email

It’s no secret that so far in 2022 things have been rocky in the financial markets. Both equities and fixed income indices are in double-digit negative territory though mid-May. The Fed is raising interest rates and shrinking its balance sheet to help control inflation, the cost of borrowing has increased and  earnings for many organizations are declining.

Plans that have a Liability Driven Investment (LDI) strategy have most likely fared well so far in 2022 as higher interest rates and wider corporate bond spreads have driven reductions in pension liability values. These reductions have in most cases offset investment portfolio losses. However, if the economic situation continues to deteriorate, leading to a more challenging corporate credit environment, we see the potential for unexpected losses and frustration on the part of plan sponsors. With that potential comes an opportunity that plan sponsors should not overlook.

This article explores what could go wrong for plan sponsors that employ LDI strategies and what they should be thinking about to try to manage this risk.

Matching Assets to Liabilities

Corporate pension plans value their liabilities using yields based on high-quality corporate bonds. Many pension plans use derived yield curves like the FTSE Pension Discount Curve as the basis for these calculations. While these curves are great for coming up with a market-related value of yields, the curve itself isn’t actually investable.

Because these yield curves are not investable, investment consultants and managers will help construct liability matching fixed income (i.e., LDI) portfolios that attempt to mimic the behavior of a pension liability based on this yield curve model. This typically involves the use of a number of different instruments like Treasury securities (both STRIPS and par bonds), corporate bonds of various credit quality, and high-yield bonds to achieve the right match in yield, duration, convexity, etc.

Here’s the Problem

The yield curves that are constructed to value liabilities are based on a universe of high-quality, investment grade bonds. If a company that is in this universe starts to struggle, increasing its risk of bankruptcy, then the yield on its bonds relative to Treasuries or bonds of companies that are not struggling will widen. At first, this is a good thing for a pension plan sponsor – higher yields mean lower liability values.

But if a bond drops far enough in quality (for example if it is “downgraded” sufficiently) then it will be removed from the universe and will no longer factor into the yield curve calculations. The liability discount rate can drop suddenly, especially if a number of bonds drop in quality all at once as has happened before in recessions. On the asset side, if a pension plan is holding the bonds whose yields widened, that negative performance shows up in lower asset values.

Bond downgrades have the potential to cause unexpected funded status losses as they are removed from the liability calculation but continue to affect asset values. In times of economic uncertainty like we find ourselves in today, the possibility of downgrades increases. If that happens on a large scale, it’s not unfathomable that pension plans could lose meaningful ground on an LDI strategy that plan sponsors thought was protecting the plan from adverse interest rate movements. This is exactly the situation plan sponsors found themselves in during the Great Financial Crisis when many financial sector bonds were downgraded and plans lost ground due to the mismatch in their liabilities and assets.

What Should Plan Sponsors Do Now?

Pension plan sponsors should evaluate whether the risk in their LDI portfolio makes sense. For many sponsors, that means looking at whether the amount of risk in credit (i.e. corporate bonds) is appropriate or if a higher allocation to higher quality credit, or to government bonds might be a better option.

This issue is even more critical for pension plan sponsors going through the plan termination process, as downgrades or defaults can lead to unexpected contributions when the liabilities are settled.

Increasing exposure to higher quality corporate bonds, or to US Treasuries versus broad quality corporate bonds can reduce downgrade risk and position the plan to benefit if credit spreads continue to rise. At a later point, the reverse can be done, locking in the potential for higher returns. Having an advisor to help manage this strategic risk management process is critical to supplement the more tactical strategies employed by active fixed income managers.

INVESTMENT ADVISOR:  Investment advisory services are provided by River and Mercantile LLC, an investment advisor registered with the US Securities and Exchange Commission.

The information contained in this document is strictly confidential. The information contained herein may not be reproduced, distributed or published by any recipient for any purpose without the prior written consent of River and Mercantile LLC.

PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.

The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. No representation, warranty, or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this document by River and Mercantile LLC or any of its partners or employees and no liability is accepted by such persons for the accuracy or completeness of any such information.

R&M investment consulting

From asset allocation and fund manager selection to risk management and ongoing governance support – we understand that your world is complex.

We tailor our advice to your needs.

R&M-18.1-MACRO-FIRST-RIGHT

Latest perspectives

Pooled employer plan fee arrangements

Pooled employer plan fee arrangements

Article June 16, 2022

Article June 16, 2022 Pooled employer plan fee arrangements Written by Tom Cassara Mike Lynch…

4 min read

US pension briefing – May 2022

US pension briefing – May ...

Article June 8, 2022

Article June 8, 2022 US pension briefing – May 2022 Written by River and Mercantile…

3 min read

Pension plan annuity purchase update – Q1 2022

Pension plan annuity purchase update ...

Article June 6, 2022

Pension buyout sales totaled $13.7 billion in Q4 2020, which represents the highest quarterly sales…

2 min read

Why you need to know and understand pooled employer plans

Why you need to know ...

Article May 31, 2022

Article May 31, 2022 Why you need to know and understand pooled employer plans Written…

3 min read

Stay ahead of the curve by receiving our newsletter containing current industry developments and insights.