A guide to navigating the current crisis
As plan sponsors and investment managers, we find ourselves in precarious times. Over the past several weeks, our lives have all been turned upside down. As we adjust to this new way of living and doing our part to protect our families and others, we’ve been caught fighting not only a healthcare battle, but also a financial one.
Those of us who were asset owners during the 2008 global financial crisis will no doubt recognize many similarities in terms of the fear and anxiety around decision-making. While the financial system today is by no means under the same level of stress as it was back in 2008, this crisis has given us all pause to step back and reevaluate our investment strategies. This recent market drawdown happened extremely quickly and, as a result, was difficult to anticipate for even seasoned investors. As we reexamine our own plans, and help our clients navigate this perilous environment, we highlight some of the key issues and concerns that we believe plan sponsors should be thinking about.
What have you likely experienced?
Unless you were one of the fortunate few to have fully derisked your plan, you likely experienced a deterioration in your plan’s funded status through the end of Q1. We highlight below a few examples of varying asset mixes from a traditional balanced 60% equity/40% fixed income mix to a 20% equity/80% liability-driven investment (LDI) portfolio. In all cases, plans that started off the year fully funded saw a potential decline of up to 16 percentage points.¹ Such a dramatic fall would clearly have a significant impact on a plan sponsor’s ability to make necessary contributions and almost certainly alter the plan’s return on asset requirements necessary to reduce the funding gap.
There’s no question in our minds that we now find ourselves in a bear market and a global recession unprecedented in its cause. As scientists and the healthcare community continue to grapple with COVID-19, many investors find themselves struggling with what to do next in their portfolios. The significant increase in monetary and fiscal stimulus from central banks across the globe has helped to provide some support for markets, although we won’t know the full extent of their efficacy for some time. While it’s impossible to predict how many months or quarters of continued volatility and uncertainty lie ahead, there are several things you can do today to help ensure future investment success.
What are we focusing on in the management of our own plans?
As managers of our own internal pension plans, we’re spending our time focusing on four key areas: funding levels, liquidity, rebalancing, and evaluating our managers.
- Funding levels. Getting a baseline on your plan’s funded status is the most critical starting point. Since the 2008 financial crisis, many plans have adopted more frequent monitoring of their funding levels, but some still lack the full transparency necessary to react dynamically to changes. We’re evaluating our levels in relation to the current market environment so we can fully understand any impact on our investments and contribution policies.
- Liquidity. Near-term liquidity has been front and center on plan sponsors’ minds in the hope of avoiding a repeat of the challenges that arose in fixed-income markets during the 2008 financial crisis. Having access to cash became a commodity as money markets “broke the buck” and commercial paper markets froze up. Fortunately, those lessons appear to have been learned, and we‘ve seen a tremendous monetary and fiscal response from central banks, which has helped instill confidence and keep money moving. This doesn’t mean that liquidity now comes for free, however. We recommend carefully evaluating your portfolio, including any positions that have infrequent redemption windows, in order to fully understand the liquidity risk of not being able to make pensioner payments. Focusing on positions with the least amount of friction is important in order to avoid unnecessary transaction costs. Longer term, this crisis should give plan sponsors pause to evaluate the balance between the allocation of public and private assets and their ability and willingness to assume liquidity risk.
- Rebalancing. The recent drawdown in equity markets has left most pension plans significantly underweight in equities in relation to their investment policy and procedures. It’s difficult to know the appropriate time to rebalance back toward stated long-term targets: Calling a market bottom is a thankless task and not an activity we’d recommend. However, given the decline in valuations, careful investors can find longer-term value. We’re using the market dislocation to evaluate those asset classes and managers that we believe will serve us best in the eventual rebound. For those plan sponsors with the flexibility to actively manage their asset allocation outside of the traditional quarterly committee process, we believe there is an opportunity to selectively reduce any major underweights in the portfolio.
- Evaluating our managers. Market events such as these give us as plans sponsors the opportunity to carefully evaluate the managers that we’re invested with. Managers are hired to perform against a stated objective of what types of market environments they’re expected to perform best in. Markets such as this test active managers’ abilities to add value both on the downside and on the rebound. We’re taking time to review our managers’ performance and ensure their value propositions are intact. We suggest plan sponsors use this time wisely and increase communication with their managers to fully understand their exposures and their philosophy for navigating the current crisis.
Potential solutions when managing assets in the context of liabilities
In addition to overseeing our own internal pension plans, we also manage assets and advise on several OCIO and LDI strategies for a wide variety of plan sponsors and corporations around the globe. With our broad perspective, we view the current crisis as an opportunity for our clients to review their investment beliefs and make adjustments as necessary. To this end, leaders should take the time to assess their current situation and, depending on the structure already in place, either improve on the core investment strategy or seize the occasion to build a road map for the future.
Road map for large plans: improve on core strategy
For sponsors who already have a solid foundation in place, often designed in the wake of the global financial crisis 10 years ago, the current environment offers an opportunity to build on this base. Below are several action points that decision-makers can consider to improve on what they already have in place.
- Rebalancing: unintended consequences?
An often missed and unintended consequence of rebalancing actions between the liability-hedging assets and the risk-seeking assets of an LDI plan is a decrease in the interest-rate hedge ratio. Equities typically suffer more than fixed income in a market sell-off, so the rebalancing action would be to sell out of fixed income and reallocate to equities. The unintended decrease in the interest-rate hedge ratio, if nothing is done, could put the funding ratio of the plan further at risk as the path of rates is unknown, and long discount rates could decrease further in difficult economic times. To alleviate this impact, decision-makers can consider decoupling the asset allocation decision from the interest-rate hedge ratio by using an LDI completion management approach with or without leverage.
- Corporate credit exposure: revisiting the allocation
With corporate credit spreads widening significantly, it might be a good time to revisit the strategic allocation to the corporate bond sector. Defining the right allocation in the context of liability valuation methods can help identify sector allocation gaps and improve the tracking error between a custom benchmark and the liabilities.
- Real return bonds: a buying opportunity?
With the real return bond market showing signs of dislocation, with break-even inflation yields dropping below 1%, sponsors with pension payments indexed to the consumer price index may want to revisit their inflation risk coverage. A market with such low implicit inflation can either be viewed as a buying opportunity or a sign that low inflation is here to stay. We offer a warning that in times of disrupted markets, the way fixed-income securities are traded by market participants might be driven more by forced selling in order to generate liquidity than to express a view about future inflation.
- Private/real assets: diversify, diversify, diversify
Diversification is the basic principle of investing and is just as important in the context of private/real assets. As the crisis continues to unfold and certain sectors of the economy are hit harder than others, the benefits of diversification in public and private assets are plain to see. Sponsors, therefore, might want to consider revisiting their portfolios and seek out opportunities to add different asset classes to their core private and real assets allocation.³
- Gliding into more interest-rate coverage
Once again, the current crisis highlights the fact that the course of interest rates is difficult to predict, and even in this low interest-rate environment, further interest-rate declines are possible. This reinforces the need to properly frame the management of a derisking plan and a glide path with the ability to dynamically move into more interest-rate coverage as the markets return to normalcy and the health of plans start to improve. More frequent liability valuations and assessment of the financial position of the plan should allow for more nimble transactions and a diversification of entry points into the fixed-income market through dollar cost averaging.
Road map for small plans: implement an agile framework
For sponsors and corporations without the internal resources and time to implement more complex strategies, these uncertain times might present an opportunity to refocus the various stakeholders and implement an agile framework to better manage pension risk. The market has evolved tremendously over the past few years and now offers a number of solutions previously only available to the largest asset holders.
- LDI
A variety of LDI pooled solutions with specific exposures to either the government or corporate sectors can allow for a tailor-made approach in managing fixed-income assets against pension liabilities.
- Leverage
The use of leverage through a pooled solution can improve the interest-rate hedge ratio of the plan without sacrificing the allocation to risk-seeking assets and requiring heavier operational processes.
- Access to private/real assets
It’s now possible to have a single-entry point into a fund providing a diversified exposure to a variety of private/real assets. We believe this is an ideal opportunity for sponsors to either consider an allocation to private/real assets as a means of diversifying their risk-seeking assets, or to review their existing allocation to potentially broaden the scope of asset types, again in the interests of diversification.
- Dynamic glide paths
The good news for smaller plans is that it’s not too late to put in place a framework, including a dynamic derisking glide path. As the current environment makes asset allocation decisions challenging, a glide path can help better frame asset allocation decisions. A more hands-on approach can be taken through an LDI packaged solution or a more hands-off approach can be adopted by delegating more responsibilities to the manager through OCIO mandates.
1 Changes of funded status globally from December 31, 2019 to March 31, 2020. See chart for further details. 2 Canadian Pension 60/40 is represented by 30% S&P/TSX Composite TR; 15% S&P 500 TR CAD; 15% MSCI EAFE GR CAD; and 40% FTSE TMX Canada Universe TR. Canadian Pension 20/80 LDI is represented by 10% S&P/TSX Composite; 5% S&P 500 TR CAD; 5% MSCI EAFE GR CAD; and 80% MIM LT Liability Gov PF Bench. Liability is represented by100% MIM LT Liability Gov PF Bench. US Pension 60/40 is represented by 30% S&P 500 TR; 30% MSCI EAFE GR USD; and 40% BbgBarc US Ag Bond TR. US Pension 20/80 LDI is represented by 10% S&P 500 TR; 10% MSCI EAFE GR USD; and 80% BbgBarc US Corp Aa Long TR. Liability is represented by100% BbgBarc US Corp Aa Long TR. UK Pension 60/40 is represented by 60% MSCI ACWI GR GBP; and 40% BbgBarc Global UK TR. UK Pension 20/80 LDI is represented by 20% MSCI ACWI GR GBP; and BbgBarc Long Term UK TR. Liability is represented by 100% BbgBarc Long Term UK TR. 3 Diversification or asset allocation does not guarantee a profit nor protect against loss in any market.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
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