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Public DB Plans: Pursuing Inflation Protection Without Compromising Return Prospects

Embedding inflation protection within equity exposures may help public defined benefit plans achieve return targets.

Cost-of-living adjustments rank among the most valuable benefits offered by public defined benefit (DB) pensions. But the need to tie benefits to inflation often clashes with investment strategies designed to achieve ambitious expected return on assets (EROA) targets. However, we believe an option exists – a capital-efficient approach in which traditional equity mandates are converted into synthetic equity backed by physical Treasury Inflation-Protected Securities (TIPS).

Unlike corporate plan sponsors for whom liabilities generally fall when inflation rises – the commensurate increase in the discount rate reduces liability valuations – public DB plans typically face rising liabilities when inflation picks up as cost-of-living adjustments get factored in (all else equal). On the other hand, most public pension plans hold few, if any, assets that provide direct inflation sensitivity. They are thus unlikely to get near- term inflation-driven asset appreciation to offset higher liabilities.

Inflation has been low due to depressed economic activity amid the COVID-19 pandemic, but in our view the risks of inflation overshoots ahead have meaningfully increased due to massive coordinated monetary and fiscal stimulus, rising debt levels, and accelerating de-globalization. Also, after undershooting its 2% inflation target since 2012, the Fed would likely welcome above-target inflation.

EMBEDDING INFLATION PROTECTION WITHIN EQUITY EXPOSURES

Ideally, plan sponsors could gain exposure to inflation-sensitive assets (like TIPS) without having to lock-in the returns for these assets, which are meaningfully lower than public DB plans’ EROA targets. This type of “have-your- cake-and-eat-it-too” objective could be accessible to plan sponsors who believe a capital-efficient approach may be appropriate for their plan.

In order to maintain a significant exposure to equities or other risk assets to pursue return targets while also obtaining exposure to inflation-sensitive assets, we believe public DB plans should consider whether it may make sense for their plan to convert their traditional (physical) equity mandates into synthetic equity backed by physical TIPS collateral. As Figure 1 shows, this approach could help plan sponsors capture equity-like returns on top of realized inflation.

Figure one shows a series of boxes arranged left to right as an equation: equity beta, plus inflation protection beta, plus potential alpha, all add up to equal portfolio return. The box with equity beta shows a bar, whose height indicates the biggest part of the return. Inflation protection beta is made up of shorter bars representing TIPS (U.S. Treasury Inflation-Protected Securities) beta return, less the short-term money market rate. Potential alpha, shown as a short bar, comes from an actively managed TIPS portfolio. The total return is shown as a tall bar on the right, stacked with the various components.

The strategy may provide a number of important potential advantages to public DB plans by:

  • Using the TIPS collateral to provide inflation protection against liabilities. The total equity return can now contribute to funding ratio improvement (as opposed to being reduced by the amount needed to cover liability growth related to inflation indexation).
  • Boosting diversification by adding real duration, which tends to have a low correlation to equity. This could be particularly beneficial in severe market downturns as plan sponsors could source benefit payments from TIPS (which are likely to appreciate if real rates decline) as opposed to crystalizing losses by selling equities.
  • Delivering incremental carry, relative to a traditional equity exposure, to the extent that the combination of the real rate of return and inflation adjustments on the TIPS collateral exceeds the financing rate of the equity derivatives position.

IMPLEMENTATION CONSIDERATIONS

Plan sponsors will need to ensure they can effectively manage the TIPS collateral portfolio and have sufficient liquidity to meet margin calls on the equity overlay portfolio. The strategy also requires regular rebalancing between the equity component and the TIPS collateral as the two fluctuate in magnitude and direction.

A comprehensive approach – equity beta via futures and swaps and TIPS collateral – may help address implementation considerations. We have written previously about the potential benefitsof active TIPS management, and here we note that active management helps investors to position appropriately even in periods when inflation surprises on the downside, for example via the use of inflation swaps.

A CLOSER LOOK AT TIPS

TIPS are an appealing collateral because they are U.S. government guaranteed, relatively liquid, and have exhibited a low correlation to the equity overlay. Their coupon and principal adjust with CPI inflation, providing a hedge against inflation.

Analysis of the asset class has been constrained by its relatively short history (they were first issued in 1997), but fortunately the Federal Reserve Bank of New York has created a history of U.S. inflation expectations using statistical techniques to derive synthetic TIPS real rates and implied inflation breakeven rates back to the 1970s. We use these data to calculate synthetic TIPS returns and correlations for a more robust historical analysis of the asset class.

We believe TIPS have particularly powerful benefits when combined with equities. As Figure 2 shows, stock-bond correlations tend to increase with inflation, but stock-TIPS correlations decline as inflation rises, boosting diversification benefits.

Figure 2 shows two scatterplots, showing 3-year annualized inflation versus 3-year stock-bond correlation in one graph, and versus 3-year stock-TIPS correlation in the other—for the time period December 1977 to June 2020. Inflation is shown on the X-axis. For inflation versus stock-bond correlation, shown on the left, the plots form upward sloping curve, with its slope steeper at lower rates of inflation. Most plots fall with correlations of negative 40% and positive 60%, and 1% and 10% inflation. On the other graph, on the right, the average of the plots of inflation versus stock-TIPS correlation is a slight downward sloping curve, and almost linear, close to the X-axis. Most plots are between negative and positive 40% correlation, and 1% and 10% inflation.

PORTFOLIO IDEA: TIPS-BACKED EQUITIES

An investor could combine separate allocations to U.S. equities (S&P 500 Index) and U.S. TIPS (Bloomberg Barclays U.S. TIPS Index) into a single, equities-backed-by-TIPS portfolio.1 The resulting capital-efficient portfolio would amplify the market exposure to each of the two assets without requiring additional capital – i.e., $100 can provide $100 of S&P 500 exposure and $100 of TIPS exposure, less financing costs. (Note, although we use the S&P 500 as an example, the same concept applies to virtually all equity betas.) See Figure 3.

Figure 3 is a line graph showing the hypothetical growth of $100 of equities backed by TIPS, compared with the performance of the S&P 500 index and U.S. TIPS, over the time period 1997 to 2020. All grew over time, yet bottom near $100 in late 2008 or early 2009. After that, equities backed by TIPS increased at a much steeper rate than the benchmarks, growing to almost $1,200 by 2020. That compares with about $600 for the S&P 500, and $350 for U.S. TIPS.

By applying the Federal Reserve’s history of calculated real rates that pre-date the 1997 advent of U.S. TIPS, we can generate an even more complete data set. Since 1977, in a hypothetical portfolio following this construct the equities-backed-by-TIPS portfolio would have meaningfully outperformed both stocks and TIPS, on a standalone basis (see Figure 4). Not only were absolute annualized returns higher, so too were risk-adjusted returns (the Sharpe ratio). This capital- efficient structure of equity backed by inflation-linked bonds has benefited historically by allowing upside capture in risk-on markets, downside avoidance in risk-off markets, and by preserving purchasing power in periods of rising inflation.

Figure 4 is a line graph showing the hypothetical growth of $100 of equities backed by TIPS, compared with the performance of the S&P 500 index and U.S. TIPS, over the time period 1977 to 2020. Equities backed by TIPS increased at the fastest rate, particularly after the financial crisis in 2008 and 2009, rising to a value of about $18,000. Over the same period, U.S. TIPS rose to a little more than $10,000, while that of U.S. TIPS rose to about $1,500.

Since 1977, the equities-backed-by-TIPS portfolio would have achieved improved returns, with only modestly higher volatility than equities, and a significantly improved Sharpe ratio (see Figure 5). Inflation beta, or portfolio sensitivity to unexpected changes in inflation, also improved (i.e., it’s less negative). It’s important to note that higher inflation beta is preferable (it has less inflation risk), but does not need to necessarily be positive because it may be suboptimal to hedge all inflation risk, and investors still realize an improvement in beta from -2.48 to -1.39 in this example.

Figure 5 is a table showing returns of equities backed by TIPS, compared with those of the S&P 500 Index and U.S. TIPS, over the time period 1977 to June 2020. Data on return, volatility, Sharpe ratio, ex-ante inflation beta, and equity beta are included within.

If we zoom in on periods of rising CPI inflation, we see the power of combining stocks and TIPS. Since 1977, there have been 126 periods in which the 12-month change in inflation rose by more than 1 percentage point (note: We are referring to the year-over-year change in inflation, not the inflation level). During these periods, on average the equities-backed-by-TIPS strategy outperformed stocks by roughly 5 percentage points as TIPS typically have strong absolute returns in periods of rising inflation (see Figure 6). While this paper focuses on the risk of inflation, deflation is also a possibility, and investors should weigh the risks of a broad range of potential outcomes. Real TIPS yields, which are currently negative, could limit total return from the TIPS portion of the portfolio. However, that does not preclude potential positive contributions from inflation accruals and changes in real yields.

Figure 6 is a table that shows average 1-year returns for equities backed by TIPS, U.S. TIPS and the S&P 500 Index for periods when inflation is rising, from December 1977 to June 2020. Data, which includes 126 periods when year-over-year CPI change is greater than 1%, is detailed in the table.

CONCLUSION

The risk of higher inflation in the post-COVID-19 world has meaningfully increased. Investors exposed to inflation risk, such as DB plans, have been in a tough spot having to balance the need for returns to meet EROA targets and for inflation protection to hedge risk embedded in their liabilities.

The capital-efficient approach combines equity beta and actively managed TIPS, and aims to meet both needs simultaneously. The stock-TIPS combination may help improve funding ratios by potentially producing improved returns over equity-only allocations, and may do so in a more diversified manner – especially in market downturns when plan sponsors may source benefit payments by selling likely-to-appreciate TIPS as opposed to realizing losses by selling equities. And finally, TIPS are an appealing choice of collateral due to their high quality, relative liquidity, historical low correlation to equities, and as an added bonus, the potential for active alpha generation.

1 The portfolio comprises 100% S&P 500 Index and 100% Bloomberg Barclays US TIPS Index less the 3-month Libor financing cost for the equity derivatives. This does not account for some small hedging and rebalancing costs.
The Author

Rene Martel

Head of Retirement

Daniel He

Portfolio Manager

Georgi Popov

Product Strategist

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Disclosures

The information included here is not based on any particular financial situation, or need, and is not intended to be, and should not be construed as a forecast, research, investment advice or a recommendation for any specific PIMCO or other strategy, product or service. Individuals should consult with their own financial advisors to determine the most appropriate allocations for their financial situation, including their investment objectives, time frame, risk tolerance, savings and other investments.

The analysis contained in this paper is based on hypothetical modeling. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program or strategy.

One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading or modeling does not involve financial risk, and no hypothetical example can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses, are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

Figures are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

Bloomberg Barclays U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation-Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $500 million par amount outstanding. S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market. The 3 Month USD LIBOR (London Interbank Offered Rate) Index is an average interest rate, determined by the ICE Benchmark Administration, that banks charge one another for the use of short-term money (3 months) in England’s Eurodollar market. It is not possible to invest directly in an unmanaged index.

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