The past decade in 2020 hindsight: pension investing
In 2019 plan sponsors witnessed a familiar, albeit more extreme, combination of returns that has also been the theme of the entire previous decade. Equities rallied, long term interest rates fell, and funding levels didn’t increase to levels that plan sponsors expected for a typical pension plan. However, some sponsors utilized equity derivatives to make the investment portfolio work harder while managing risks more efficiently, and consequently saw their plans’ funded ratios materially increase over the same time period.
2010 to 2019 in review
The chart below shows the returns for equities along with the change in long term corporate yields and the corresponding increase in liabilities. Most plans would be starting from an underfunded position at the beginning of the decade and the substantial equity market gains were offset significantly by liability growth. In absence of contributions, this would leave many plan sponsors in a flat or slightly better funded status position but probably not near their expectations – despite the substantial gains in the equity markets.
|S&P500 Equities||Global Equities||Long Yield Change||Liability Growth|
*Note: All figures over 2019 and the 10 years to 31 December 2019. Global equities is the total return on the MSCI World Index. Long Yield change is based on the average FTSE AA discount curve yield for a 13 year duration plan. Liability Growth is the compound growth of pension liabilities of a 13-year duration due to interest rates only (i.e. excluding service cost and benefit payments)
A strategy with better results
For pension plans to experience funded status improvements in line with their expectations from equity market returns, plans had to have invested differently. For example, Plans could have held a 100% allocation to liability matching bonds and obtained equity exposure by entering into a derivative contract. The market value of this derivative structure could have even initially been zero, but would have risen as the equity market rose, and fallen as the equity market fell. This strategy allows a plan sponsor to maximize their interest rate hedge, but still access the benefits of the equity markets.
In its simplest form, this rise and fall in the value of the derivative contracts provides the returns to the Plan as if it had retained a passive investment in equities. We examine below a strategy where this exposure is 60% of plan assets (in addition to the 100% physical bond holdings) and where the strategy is setup with less drawdown risk than conventional equity holdings, i.e. with some equity downside protection, but, to pay for the downside protection, the investor forgoes some upside exposure. For some plans, this upside exposure may be less valuable or potentially not even required if they are approaching a surplus position.
Comparing strategies over 2019:
In looking at how this type of strategy played out in 2019, the strategy with structured equity would have outperformed a traditional 60/40 portfolio and a more conservative 20/80 portfolio (with the fixed income invested in liability matching bonds).
Comparing strategies 2010-2019:
Over the last ten years, the difference in strategies is more pronounced. A Plan that started off at 80% funded would be over 100% funded today compared to the other strategies that would not have picked up much ground without the help of contributions.
*Charts show funding levels for plans 80% funded at 1/1/2019 and 1/1/2010 respectively. Plans have 13 year duration as at 1/1/2020, service cost of 2.5% of liabilities per annum and contributions equal to service cost. Liability Matching portfolios are a combination of 65% Barclays Long Credit and USTs to match the duration of liabilities. Equity portfolios are MSCI World Total Return. Structured equity strategies use put and call options to deliver participation to global equities with capital protection down to a 20% fall in markets over a period of 3 years, with downside participation thereafter. Equity upside above a certain level is forgone in the structured equity strategy. The strategy shown incorporates 3 year term strategies that are initiated 1/1/2008, 1/1/2011, 1/1/2014 and 1/1/2017.
- Liability Matching Bonds have delivered funding certainty and mitigated the impact of declining interest rates. However, with high allocations there is little scope for investment returns to close deficits, and there may have been regret in not having participated in the equity market rally. A plan with a 20% equity and 80% liability matching bond allocation would have seen funding ratios decline from 80% to 70% over the previous decade in this example.
- Higher equity allocations have delivered more returns but not funding level improvement in this example due to declining interest rates. A 60% equity/40% liability matching bond strategy delivered near flat funding ratios over the previous decade.
- A Structured Equity strategy consisting of 100% liability matching bonds and using derivatives to obtain a 60% exposure to the equity market minimize interest rate exposure and maintain participation in the equity market at the same time. Such strategies would have taken the Plan to full funding and possibly to termination in this example.
Future returns will not be identical to the last decade, but we expect equities will outperform long bonds over time. However, declines in interest rates, which increase the value of pension liabilities, also remain an ever-present threat. Therefore, a structured equity strategy can be expected to continue to deliver higher returns than conventional strategies while controlling risk going forward.
It is also possible to adapt the strategy in consideration of possible future scenarios. For example, if sponsors believe that coming years will bring long-term interest rates increases, the strategy presented can be adjusted to shorten the duration of the fixed income portfolio by holding some shorter-term bonds versus all longer-term bonds. This allocation would benefit more from rates rises with the intention to get to 100% funded in that rising rates scenario.
Wherever a Plan’s funded status is today, plan sponsors that want to make meaningful funded status improvements while protecting against the possibility of funded status declines must take a different view than what has been mainstream over the past decade. Plan sponsors that have adopted strategies with structured equity have outperformed the average plan by a significant margin. The exact solution can be adjusted for market expectations and starting position, but if this decade is anything like the last, it is time for Plan sponsors to look beyond traditional equity and liability matching allocations.