Liability-driven investing déjà vu
Undoubtedly marking a high point in Tom Cruise’s storied career, I have selected one of his films to serve as a defined benefit (DB) metaphor for the second time in three blogs.
This time, it is the 2014 sci-fi thriller Edge of Tomorrow, confusingly released to video under a different name: Live, Die, Repeat. (Possibly in an attempt to trick people into accidentally watching it twice.)
Whatever you call it, the story line features Tom Cruise and Emily Blunt fighting a volatile and dangerous alien force called “Mimics.” These Mimics violently strike without warning and cause extreme carnage to everything in their path.
Fortunately, Cruise’s character has the power of reincarnation. Every time he gets killed, he starts back at the beginning of the story slightly wiser from his previous painful experience. Hence the new title.
Ultimately, the accumulated knowledge from his numerous demises helps them to understand and defeat the Mimics, and get on with their lives.
Hope, Crash, Repeat
Sponsors and investment advisers tasked with managing interest rate risk in DB plans may be experiencing a similar sense of déjà vu when it comes to their funding ratios. Flailing interest rate volatility has continually wreaked havoc on balance sheet liabilities for a while now. For the third time in five years, corporate bond rates have hit a crater that will be felt by sponsors who haven’t hedged interest rate risk yet.
The repetitive and familiar nature of these episodes has employers feeling a little bit like Cruise in Edge of Tomorrow.
- “Look out! It’s a Chinese economic slowdown.”
- (Restart) “Hey, is that a Brexit coming at us?”
- (Restart) “What happened? What year is it? Why is my funding ratio down 10%?”
Unfortunately, many experiencing this recurring cycle of pain haven’t learned from Cruise and followed his lead. Rather than changing their behavior to lessen the risk of the next decline in rates, many sponsors stay the course only to go through it again. Too often the experience has been: Hope, crash, repeat.
Most people responsible for managing pension risk are at least familiar with the concept of liability driven investing. LDI suggests investing in high-quality fixed income investments with duration characteristics similar to plan liabilities to mitigate interest rate risk by having assets and liabilities react similarly to rate changes.
But with the majority of plans still significantly underfunded and interest rates near historic lows (again), many are still pondering the move. Shifting fully into long duration fixed income essentially locks in the plan’s underfunding and introduces the possibility of negative gross returns if interest rates rise – neither are ideal for a plan needing to close a large funding gap.
So they stand pat, sincerely intending to jump to LDI when the time is “right.” But the ideal opening never seems to appear.
Or does it? A closer examination of corporate bond rates since the end of 2011 tells a different story. While rates have been generally low for a long time, there are localized peaks that introduce risk reducing opportunities for those equipped to exploit them.
According to the Principal Pension Discount Yield Curve Index, a measure of high quality corporate bond rates used to calculate balance sheet liabilities, we are currently in the third major trough in the last five years. Although the dog days of summer 2016 are winding down, it feels a bit like Christmas 2014 with sponsors disclosing their pension liabilities at rates around 3.5%.
Looking at the picture more optimistically, however, there have also been three periods where rates exceeded 4.5%. Pension liabilities for a typical plan generally drop around 15% for every 1% increase in discount rates. These summits represent potential “derisking opportunities” where liabilities are lower, funding ratios usually better and the reasons not to move toward an LDI strategy diminished.
Measure, Hedge, Repeat
A dynamic asset allocation (DAA) approach is a relatively painless way for sponsors to incrementally hedge liabilities through an LDI strategy. Under DAA, a preset glide path is adopted that gradually reallocates plan assets into duration matching bonds as the funding ratio of the plan improves. This often happens when rates rise as in the “derisking opportunity” peaks above.
But it’s apparent that recent rate plateaus have been ethereal, only lasting around six months. In order take advantage of derisking opportunities effectively while they still exist, sponsors need three things:
- Identification of opportunities through regular reporting of market value funding ratios.
- A preset plan to change asset allocation as quickly as possible when the time comes.
- Effective coordination with the plan actuary and investment advisor.
By shifting slices of assets into LDI during derisking opportunities, funding ratios will better weather future rate declines when they invariably arrive. Small changes in behavior over time can accumulate to ultimate victory over interest rate risk as surely as Cruise and Blunt kicked the Mimics back to whatever lousy planet they came from.
At least I think that’s what happened at the end. I’ve only seen it twice.
A version of this blog originally ran on the Principal blog.