Under an LDI strategy, sponsors relegate assets to 2 buckets: 1 seeks protection by matching liabilities to fixed-income strategies; the 2nd looks to capture growth through equities. But simply moving away from equities is proving not enough. (Photo: Shutterstock)

All-time low discount rates that determine the cost of a defined benefit plan's liabilities, along with equity market volatility, are forcing more sponsors to re-examine the risk component in liability-driven investment (LDI) management strategies.

The aggregate funded deficit of the 100 largest corporate defined benefit plans expanded by $64 billion in the third quarter of 2019, despite an $18 billion increase in the value of plan assets, according to Milliman's Pension Funding Index.

Olivia Engel, CIO , Active Quantitative Equity Strategies, State Street Global Advisors. (Photo: State Street Global Advisors

Plan liabilities increased by $82 billion, thanks to declining discount rates. From the end of September 2018 to the end of September this year, the discount rate sank from 4.18 percent to 3.09 percent.

The funded ratio of the largest 100 plans fell from 94.2 percent to 85.4 percent over the year. By comparison, the discount rate was 7.63 percent in 1999, a time when larger pensions were running an aggregate funding surplus, according to Milliman.

Add in the return of equity market volatility experienced over the past year and a half, and sponsors are feeling the pinch in an era when more are looking to improve funded status to explore pension de-risking options.

"The majority of corporate DB plans are underfunded, and have been for a number of years, despite the massive equity bull run," said Olivia Engel, State Street Global Advisors' CIO of active quantitative equity strategies.

"Funded status has not really improved. Market volatility is contributing to sponsors' concern and nervousness about the status of plans being funded well enough," added Engel.

When plans reach the 80 to 85 percent funded status threshold, as they strive to reach full-funded status, sponsors shift to protection mode, explained Engel.

That means reducing equity exposure in the effort to protect the coffers. Over time, large pensions have shifted an increasing amount of assets from equity to fixed income. In 2018, the average equity exposure in large pensions was just over 30 percent, compared to more than 60 percent in 2005, according to Milliman's data.

Under an LDI strategy, sponsors relegate assets to two buckets: one seeks protection by matching liabilities to fixed-income strategies; the second looks to capture growth through equities.

But simply moving away from equities is proving not enough to protect assets. Nor is deploying a pure passive strategy within the growth bucket. A recent State Street survey showed nearly half of U.S. institutional investors say active equity strategies are the hedge to offsetting low-interest rates and market volatility.

"Corporations are realizing that ignoring the risk focus of their risk buckets is dangerous," said Engel. "The punch line is you can think about your growth bucket in a risk-aware way that captures growth and still has the objective of managing volatility."

Getting defensive with the equity sleeve

A defensive equity strategy carries such a dual mandate: It seeks returns with a balance of managing risk.

"It challenges the conventional wisdom that equities should only serve a growth purpose," said Engel. "But there is no reason why you can't put a dual objective on your equity bucket."

Of course, what constitutes a defensive equity strategy is open to interpretation.

At State Street, the objective is to deliver lower volatility than benchmark indices, while capturing higher returns, explained Engel.

There is a catch, she concedes.

"Some plans judge risk buckets on how they track with benchmark strategies. But if you are looking for a return stream in equities that also lowers volatility, you have to accept some tracking error risk," said Engel.

"If you are solely worried about underperforming an index, you can't build a portfolio that will reduce risk, and ultimately improve returns," she added.

A defensive strategy uses empirical data to measure returns against units of risk with the objective of generating returns in up and down markets. That portfolio will look different than a benchmark index.

"Where it would lag an index is in the short run, in an environment where there is an equity rally after a time of decline—a defensive strategy may not keep up in that market," said Engel.

That global markets have already entered a period of increased market volatility—the so-called beta bubble of the past decade is primed to burst—is a sentiment shared among institutional investors. A State Street survey of 400 institutional investors shows their main concern is heightened risk in capital markets.

But what if that sentiment proves wrong? What if trade disputes are resolved, global growth resuscitates, the American consumer remains strong and realizes further wage growth, and inflation remains in check? What if there is a breakout rally that extends the historical bull market for another two years? Or five years?

Would pension sponsors then regret a defensive strategy?

"If lagging a high-beta fueled equity rally is your concern, you would still be okay," said Engel. "If the worst case scenario is you end up with a slight amount of regret, I will take that risk. The key is to remember you can manage risk and do so with higher returns."

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