n 2014, the S&P 500 returned almost 14% yet the funding ratios of corporate defined benefit plans deteriorated by nearly as much. The reason: Both
lower interest rates and updated mortality tables that extended life expectancies boosted liabilities. The hit to funding ratios amid strong gains for
stocks underscores the potential benefit of a liability-driven investing (LDI) framework and the PIMCO StocksPLUS LDI Strategy. Pension and investment
solutions strategist Vijendra Nambiar explains.
Q: How have defined benefit (DB) plan funding ratios fared over the last 18 to 24 months?
It has been a bumpy ride! After stellar equity performance and rising interest rates in 2013, plan sponsors began 2014 in a strong position: The average
plan funding ratio rose from 77% at the beginning of 2013 to roughly 88% at the start of 2014, according to the Milliman Pension Funding Index. However,
despite strong equity market returns in 2014, funding ratios dropped to roughly 82% at year-end as plan liabilities grew faster than plan assets – the
result of declining liability discount rates and updated mortality tables that projected longer life spans. Simply put, 2013’s funding ratio gains were
erased in 2014, a pattern also seen in previous years.
Q: Given the drop in funded status, plan sponsors may consider re-risking their portfolios by boosting exposure to equities, but that would enhance
asset-liability risk. How would you address this?
Plan sponsors face two competing objectives – achieving the return needs of the plan and reducing risk relative to the liabilities, or managing funding
ratio volatility. One strategy is to bring asset-liability tenets to equity investing, an approach at the heart of the PIMCO StocksPLUS LDI Strategy. In
this strategy, we obtain equity exposure synthetically via derivatives and collateralize this exposure with an actively managed long duration portfolio
that seeks a return roughly in line with the growth of an interest-rate-sensitive liability. It is designed to provide equity returns1 over the
growth of liabilities in a single portfolio.
By combining returns from equities and long bonds, this strategy has the potential to deliver powerful benefits to plan sponsors – namely, higher return
potential from equities and the liability-hedging potential of a long duration collateral portfolio. Furthermore, the long bond portfolio has the potential
to deliver additional yield that could be used to pay benefits and smooth and improve the efficiency of glide path transitions via LDI completion
management programs. Please see the Featured Solution, “Pension Risk Management: Could Plan Sponsors Get Their (Risk-Frosted) Cake and EatIt Too?” by Rene Martel and Chantal Manseau.
Q: How have pension funds incorporating the strategy performed versus a more traditional approach?
Let’s consider the framework for StocksPLUS LDI by using a hypothetical corporate pension plan and an LDI Equity Overlay Model (based on the S&P 500 +
Barclays Long-Term Government/Credit Index – Libor). Figure 1 shows how two pension portfolios, one with an allocation to the LDI Equity Overlay Model,
have performed on a funding ratio basis:
The green line highlights the potential benefits of an LDI equity overlay strategy in a pension portfolio. Particularly noteworthy is performance over the
last five years, which spanned differing equity market and interest rate environments. The inclusion of the LDI Equity Overlay Model in Portfolio 2 helped
the plan align returns with liability growth during rising and falling interest rate regimes and across strong and weak equity markets. For example, in
2011, as the average liability grew by roughly 21% due to falling interest rates, the LDI Equity Overlay Model returned 21%, while the S&P 500
generated a meager 2% return. Even in 2012, when equities outperformed average liability returns (16% for equities versus 11% for liabilities), an
investment in the LDI Equity Overlay Model returned 28%; this would have helped the portfolio keep pace with liabilities and offset some of the funding
deficit incurred in earlier periods of market stress.
Of course, it’s possible that this strategy could have negative returns in market environments where rates are rising and equity markets are losing value.
However, in these conditions, liabilities also typically drop in value, rendering the effects potentially muted on the overall plan.
Q: Should investors be concerned about the leverage inherent in the equity overlay? Nambiar:
In the asset-liability space we would argue that it is not typical leverage. If we consider a typical equity allocation, the plan is effectively short $1
of liability risk and long $1 of equity risk. It is akin to the plan borrowing from its participants to invest in equities. Therefore, a typical equity
investment should be considered leverage in asset-liability space. The StocksPLUS LDI Strategy is designed to reduce or eliminate this leverage by
offsetting the short liability position with the underlying long bond portfolio, leaving the plan with equity market exposure on its equity investment (as
opposed to equity market exposure and a short liability position). Technically, of course, the strategy does employ a form of leverage via its use of
derivatives, albeit in a risk-focused fashion.
Q: Is now a good time to implement the StocksPLUS LDI Strategy given current market conditions?
While each plan needs to consider their investment objectives and risk tolerances, StocksPLUS LDI can be a valuable part of a firm’s pension investment
toolkit today. For plans considering re-risking, an investment in the StocksPLUS LDI Strategy provides the potential for higher long-term returns without
necessarily compromising the strategic liability hedge ratios set by the plan sponsors. The increased duration and credit spread exposure may also build a
yield cushion (which may be advantageous for servicing benefit payments) and may allow for some compensation in a rising rate environment.
Approaching this from the de-risking perspective, the average plan sponsor is still meaningfully under-hedged relative to its liabilities, and if we look
again at the LDI Equity Overlay Model, even a 30% allocation to an equity overlay backed by long duration bonds would only increase liability hedge ratios
to the range of 45%–55%2 (assuming a starting point of a 25%–30% hedge relative to plan liabilities). If interest rates were to rise from this
point onwards, given that the plan is still short duration relative to its liabilities, it should see significant funded status improvements; liabilities
would likely fall far more in value than the total allocation to long duration bond exposures. On the flip side, if interest rates were to fall even
further from these levels, the plan should be better protected than it would have been otherwise given the higher liability hedge ratios.
Q: Interest rate overlays are generally viewed as capital efficient since they can be incorporated on top of an existing plan allocation to enhance the
plan’s liability hedge. How would an investment in StocksPLUS LDI compare with an interest rate overlay?
In a traditional interest rate overlay, equity and fixed income exposures are obtained via the physical markets and additional duration exposure is gained
via swaps or Treasury futures. We would argue that an investment in StocksPLUS LDI would be just as capital efficient, if not more so, as the plan can
achieve a higher allocation to securities that have similar characteristics as pension plan liabilities – i.e., long corporate bonds in the physical
markets – while gaining equity exposure in the derivatives markets.
The PIMCO StocksPLUS LDI Strategy also has potential benefits from a collateral-management perspective. In a traditional overlay structure, the underlying
collateral portfolio tends to be positively correlated with the overlay investments (swaps or Treasuries). Thus, when fixed income markets are stressed
(e.g., rates are rising sharply), the swap or Treasury futures overlay position tends to suffer losses precisely when the underlying fixed income
collateral portfolio is losing value. While this risk can be alleviated via sound liquidity management, identifying contingent liquidity sources beyond the
underlying collateral portfolio could be a difficult challenge for plan sponsors in sudden rising rate environments.
Alternatively, with a StocksPLUS LDI investment, the collateral portfolio, which is composed of high-quality long government and corporate bond securities,
tends to be negatively correlated with the equity overlay. Therefore, during weak equity markets, which would negatively affect the equity overlay
investment, high-quality bonds in the collateral portfolio would typically appreciate as investors make a “flight to quality,” providing potential
liquidity for margin requirements on the equity overlay. This internal diversification baked into the StocksPLUS LDI Strategy is of paramount importance;
it can generate excess return potential and seamless equity exposure management in stressed market environments.
Q: What are the benefits of partnering with PIMCO
in implementing the StocksPLUS LDI Strategy?
First and foremost, we believe, is the relative simplicity of the structure. It allows investors to incorporate both the equity and long duration bond
portfolios in a single portfolio. The use of derivatives introduces collateral management requirements, and the needs of frequent rebalancing between the
equity overlay and the underlying collateral portfolio exposures can prove to be quite cumbersome.
Second, meaningful efficiencies can be attained by combining the equity and bond exposures in a consolidated portfolio actively managed by PIMCO. Most
importantly, the StocksPLUS LDI Strategy also eliminates the need for a specific overlay manager, and this, in turn, removes the need for communication and
coordination regarding target exposures, liquidity budgeting and customized risk reporting across multiple parties.