Liability-driven investing: The state of the strategy report

The combination of low interest rates, extreme market volatility, and limited funded status progress in 2020 compelled plan sponsors to reassess liability-driven investing (LDI). This reassessment revealed the impact of the market turbulence and also brought to light the strong relative performance of LDI strategies and their broader role in portfolio risk mitigation. 

2020 in hindsight

Amid historic volatility, LDI returns significantly exceeded expected returns in both 2019 and 2020, returning 14%-17% in 2019, and 12%-15% in 2020, depending on the duration of liabilities. LDI (along with U.S. Large Caps) was one of the two consistently strong positive contributors to investment portfolios. In addition to positive returns, LDI continued through 2020 to serve as a hedge for the present value of pension liabilities, which declining discount rates increase.

That being the case, we could not underestimate the impact of the current ultra-low rate environment. Despite a significant increase over the last few months, 10-year treasuries are trading at 1.55%, almost 126 basis points below where they were two years ago.

Pension plans experienced several tangible challenges coming into 2021:

1. Funding levels remain challenged, despite strong asset gains and excluding the extremely well funded and well-hedged plan sponsors.
2. A decline in expected portfolio return as fixed-income yields were low. Lower expected returns may be insufficient to meet plan obligations without additional contribution in the future.
3. Finally, the extension and expansion of funding relief has further separated the pension measures of accounting and funding purposes. LDI allocations now provide limited benefit in protecting the plan from required contribution demands.

The case for LDI

Despite the current challenges, we see a case for cautious optimism in LDI as we look ahead. 

Looking beyond the next three to six months of COVID-19-related headwinds, the economy is poised for a healthy recovery supported by monetary and fiscal policy. Inflation may potentially spike given growing reflationary conditions, but will likely remain contained due to a range of deflationary forces, including demographics, technology, income inequality, and increases in productivity. 

Additionally, the Federal Reserve has indicated we should expect the Fed Funds rate to continue to be anchored near zero for the next several years. The long end of the yield curve is likely to see continued moderate steepening as the economy recovers. The rise in rates should be limited due to the Fed’s quantitative easing program and transitory levels increased inflation. Housing and other economic sectors that are particularly sensitive to interest rates have performed well during the COVID-19 contraction. The Fed is not likely to want to jeopardize the strength in these sectors by letting rates rise excessively.

Against this backdrop, our fixed income portfolios are overweight corporate credit risk. The dislocation in March 2020 and the active new issue calendar that followed created an opportunity to increase corporate bond exposure. With the Fed’s help, liquidity in the corporate market has been restored and yield spreads have narrowed, but not to their pre-recession levels. Some of our managers are beginning to take profits in their corporate positions, but they remain overweight. The backdrop of an improving economy and diminished supply should allow for continued favorable performance from the corporate sector. 

However, as yield spreads narrow, successful investing becomes more name-specific, and plan sponsors can mitigate portfolio risk through active security selection and yield curve management. Adjusting fixed income allocations also amounts to a timing call on interest rates, which is extremely difficult to get right. Since the 2008 crisis, there have been several false starts toward higher rates, all of which have frustrated investors. Caution is necessary when repositioning fixed income allocation based on anticipation of rising interest rates. 

Given the historically low yields, investors may question their LDI positioning and long-duration corporate fixed income holdings. We do not believe one should view this allocation primarily as a yield-producing instrument—it is a hedge against pension liability measures, reducing surplus volatility. Investment-grade fixed income provides a hedge against volatility in equity markets and allows investors to take equity risk in the balance of the portfolio. In this way, LDI can provide benefits beyond interest rate shifts relative to the Pension Benefit Obligation, protecting the portfolio during periods of decline in equity markets.

Risks in perspective

There are some legitimate concerns regarding sizing the LDI allocation, as low yields both reduce expected portfolio returns and create asymmetrical return prospects with the distribution of interest rate risk skewed toward a rising rate environment. It is important for investors to evaluate the size, role and positioning of their fixed income allocation. Some questions to ask include:

1. How valuable is the liability hedge, based on the relative size of the liability to the plan sponsor, and the impact of funded status volatility and resulting balance sheet volatility to the plan sponsor? 
2. How might changes to the fixed income positioning, either size or duration, impact scenario expectations going forward? 
3. How does recently enacted funding relief affect the value of the liability hedge, given its now limited role in protecting against a spike in required contributions?

Portfolio shifts might include reducing duration of the investment grade portfolio or reallocating a portion to higher returning assets. However, the challenges to alternative strategies are meaningful. Changes will expose the portfolio to a new set of risks, including a potential reduction of the pension liability hedge and investing in other asset classes, which may also be stretched in terms of valuation. The most critical is the timing decision on reestablishing the liability hedge, which will be extremely challenging.

Plan sponsors will want to preserve a strategic approach to pension risk management and avoid unconditional hedge reductions. They should have a re-entry plan and set of triggers for their LDI strategy. In re-evaluating those strategies, plan sponsors should consider the following factors: 

• How significant is the liability relative to the plan? What is the capacity to fund the pension liability with assets in place, returns and other sources of capital? What are the implications of funded status volatility on the plan sponsor?

Efforts to address the challenge of low yields by reallocating to riskier assets with higher potential returns carries lower projected pension costs but greater funded status volatility. In adverse market conditions, these efforts may prove more expensive. Are those trade-offs worth modifying the current pension strategy?

• What is the appropriate response to changes in discount rates? In many cases, while the funded status has experienced limited progress (as measured by the present value of the pension liability), economic progress continues to be made. Plans have reduced their nominal liability through significant benefit payments over the past ten years while asset values either remain stable or rise. 

From a purely economic standpoint, most pension plans are in a better condition now than they were five years ago, despite limited funded status progress on an accounting basis. Rather than evaluate progress on accounting measures of funding levels, plan sponsors should closely evaluate the size of their asset pools relative to projected payouts, and return requirements needed to meet those future payouts. 

2021 implications

In 2020, a historic pandemic shook investor confidence across asset classes and investment strategies. This year, investors naturally want to reassess their strategic and tactical positioning. LDI portfolios are no exception, especially because of their sensitivity to changes in interest rates. The re-assessment of LDI strategies (as any strategy) needs to have discipline and be holistic, incorporating plan sponsor characteristics, pension-specific factors and market conditions. LDI, appropriately sized and understood, can continue to benefit from LDI’s positive impact on risk-adjusted portfolio performance.

Tom Harvey serves as a Director of the Advisory Team within the Institutional Group of SEI.

Information provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company.  Investing involves risk including possible loss of principal. There can be no assurance goals will be met nor that risk can be managed successfully. This material represents an assessment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.