Economic and Market Commentary

A Perspective on LDI and Rebalancing

Rene Martel, head of retirement at PIMCO, and Chantal Manseau, head of U.S. corporate client practice, address top-of-mind-questions for DB plan sponsors about market volatility, the rate environment and their LDI portfolios.

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Chantal Manseau, Head of U.S. Corporate Client Practice: Hi my name is Chantal Manseau and I head our US corporate practice here in Newport Beach. Given the large moves in recent weeks in both the equity and fixed income markets, many defined benefit pension plans have seen their funding status deteriorate with the average plan in our estimates in the low 70s currently.

In that context, and with rates reaching all-time lows, plan sponsors might question whether it is still worth hedging the interest rate risk. Practically speaking, those large market moves are also requiring plans to rebalance to a target asset allocation, which could be more difficult and potentially more costly to implement in those volatile markets.

So what should plan sponsors consider in this environment as they need to rebalance? To answer those questions, I'm joined by Rene Martel, PIMCO's head of retirement. So Rene let's start with interest rate risks; should plan sponsors still consider hedging that risk or given current level should they embrace it?

Rene Martel, Head of Retirement: Well there are certainly a lot of eye-catching headlines about the current level on the ten-year rate that's below 1%, but and understandably plan sponsors will question whether they need to continue to edge that risk using LDI allocation as Treasury rates are moving closer to depth arbitrary zero line.

It's important however to remember that corporate pension liabilities are not priced based on the level of the ten-year Treasury rate or any Treasury rates for that matter. 

Corporate bond rates, especially the longer dated ones, is what drive pension liabilities. And with the new level on long corporate indices still in the neighborhood of slightly above 3%, we think it would be very premature for plan sponsors to assume that there's little to no risk going forward in discount rates. Add to that the fact that with an initially lower level of yield, smaller declines in interest rates from here could create the same damage as larger ones had in the past. For example, if you consider not just convexity effects, but also the fact that initial liability valuations are higher right now, as little as 30 to 35 basis points decline in discount rates from here would have the same impact as a full hundred basis points would have had say at the height of the last financial crisis in October of 2008. 

So if you put all this together we think there's no impetus for plan sponsors right now to reduce their liability edging targets whether they're expressed as a hedge ratio that they need to achieve or the amount of assets that's allocated to LDI.

Chantal: Okay that makes sense from a strategic basis, but what about those plans sponsored that want to be tactical? Some historically have been comfortable deviating from their strategic hedge targets and implement their own views of rates. So they perhaps might consider the current environment to implement those tactical views. 

Rene: I think that with the current amount of volatility and uncertainty in rate markets the more tactical plan sponsors should first ask themselves if their level of conviction on the future path of interest rates is at least comparable to the one they had in the past when they implemented some of those tactical deviations. This may be a different market environment out there, but let's assume one still wants to move forward. 

It's important to recognize that those type of market timing calls are by definition temporary. If plan sponsors are right and rates rise, there will come a point in time where they'll want to go back to the strategic edge targets and in that context. We believe it would be more efficient for plan sponsors to implement those views using synthetic instruments like Treasury futures or interest rate swaps as opposed to selling long bonds in the physical market that they might have to repurchase in short order if their view comes to fruition rapidly. 

Proceeding with synthetic instruments may potentially help plan sponsors achieve really two things; first they'll be able to mitigate transaction costs which are likely to be elevated in the kind of market environments that we're facing and second, they'll improve their speed of implementation so after their view comes to fruition they'll be able to lock in those gains more rapidly than if they had to trade in the physical markets. 

Chantal: So Rene, from a practical perspective as I mentioned most plans governance would require them to rebound given the moves in both equities and fixed income market. So how should plan sponsors consider the rebalancing in the current environment?

Rene: First and most plan sponsors will probably not have that kind of latitude but if they do and they believe that we're entering into an elevated risk environment compared to that of the last ten years, it might be worth considering if their current asset allocation targets are still appropriate. And if one concludes that they'd like to move to a lower risk position, then it could be accomplished simply by foregoing rebalancing. Now for those who really need to get back in line with targets there are a number of options available luckily. 

I mean it could be as simple as if you have planned contributions to the plan to direct those towards the asset classes that are underweight. 

Now for those for whom this will not be enough and that will really need to adjust exposure across the different asset classes, they should think about how fierce the recent moves have been in rates and equity markets. And it would probably be imprudent to ignore the possibility that those move reverts with the same vehemence here. 

So given that again we would recommend tapping that derivatives market to execute rebalancing. This will help plan sponsors avoid undesirable outcomes and the costs that are associated with transacting in physical markets especially if you have to go round-trip in short order. For plan sponsors that use a completion management approach already, this should be very straightforward to implement using derivatives. For those who don't, then this may be the opportunity to introduce that facility within the plan and obviously at PIMCO we'd love to work with those plan sponsors and help there.

Chantal: Thank You Rene in those challenging times your team at PIMCO is ready to help with any questions related to the market or specific to your pension plan. We look forward to the continued dialogue. Thank you

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