Most pension plans across the U.S. are still following the same incremental de-risking plan they adopted in the years immediately after the global financial crisis. Specifically, replacing return-seeking assets such as equity with long-duration fixed income that seeks to match the liability. In re-evaluating these glide path strategies in the current environment, it appears that most plans have de-risked far enough to avoid serious risks and to continue would simply increase costs and inefficiency with no discernable benefit, says Jared Gross, Managing Director and Head of Institutional Portfolio Strategy for JP Morgan Asset Management. II recently asked Gross to describe the course correction he’s urging pensions to make before they face the consequences of an outdated investment approach.
You have had a ringside seat the evolution of pension strategy over the past 20 years. How far has it come since then?
Jared Gross: Prior to early 2000s, plan sponsors were focused on generating high returns with a traditionally diversified asset allocation – mainly stocks and core bonds. In many respects, this approach was appropriate given the rules in place at the time. Accounting and regulatory standards were mild, with only a limited pass-through from funding changes to required contributions or the financial statements. Pension investors generally didn’t consider liabilities when allocating assets. After all, a long period of strong returns had left most plans in a surplus position.
This era ended with the tech bust in the early 2000s, and the decline in interest rates that rapidly followed. The fallout led to a massive downturn in the funding of defined benefit plans; most went from being overfunded before 2000 to significantly underfunded just a year or two later. That was the first wake-up call. No one really had to confront the asset-liability mismatch in pensions before. Not too many years later, the global financial crisis delivered another blow, and sponsors began responding by starting to re-risk their asset allocations, closing and freezing defined benefit plans, and moving employees to defined contribution plans that offered the promise of more predictability.
How have you seen that de-risking process evolve?
I think we have seen two broad phases of pension de-risking with liability driven investments, and I believe we are about to enter a third.
The first phase, which I refer to as LDI 1.0, involved moving from shorter to longer duration bonds during the period immediately following the global financial crisis. With LDI portfolios offering high levels of yield, this was an unusual opportunity to reduce risk while also increasing return. Within a few years, most plan sponsors had moved their fixed income to a long-duration benchmark, often starting with the Long Government Credit Index.
Since then, we have seen a long process of patient de-risking that I refer to as LDI 2.0 or the “Glidepath Era,” in which plans have just been waiting for incremental improvements in funding before shifting capital from return-seeking strategies to LDI strategies. They’ve developed increasingly customized hedging strategies, many of which involve custom fixed income benchmarks, derivative overlays, and completion management. While the complexity of these hedging strategies has increased, their diversification has not. Most plans have reached a point where the exposure to investment grade corporate credit is the largest risk in the asset allocation.
Today, however, we need to reconsider the glide path approach for two reasons. First, higher funding levels and lower volatility asset allocations have reduced pension risk to a very low level already. And second, the rules that govern mandatory plan contributions have been dialed back to the point that contribution risk is minimal, if not nonexistent. It is very hard to see the value in further concentration in long-duration bonds.
If you don’t see plans continuing to de-risk, then what actions do you see them taking?
Given this backdrop, plan sponsors need a course correction. They’ve already done an enormous amount of de-risking – consider that volatility is dramatically reduced even in plans that are only 50% hedged. Pushing further down the glide path rapidly becomes inefficient. That “last mile” is very expensive; giving up significant returns to reduce volatility only slightly makes it an extremely costly form of hedging. If the risk of large mandatory contributions was a serious concern, this behavior might be justified, but it is not.
This brings us to an inflection point in pension strategy. What I think of as LDI 3.0, or as we describe it to our clients, “Pension Stabilization”, is a more balanced approach than traditional LDI. It aims for a long-term blend of modest excess return and low volatility – but not the lowest possible volatility. It’s definitely not a journey back to 1999 when plans were seeking high returns and ran 12-15% annualized funding volatility. A stabilization strategy begins when a plan approaches full funding and adopts a sensibly de-risked and diversified asset allocation, allowing for the gradual improvement in funding across time while preserving numerous positive financial benefits for the sponsor. I expect that many sponsors will see the appeal of taking this “off-ramp” from an outdated glide path.
Why is it so difficult to completely hedge the risks in a traditional pension plan?
Simply put, it’s impossible to perfectly hedge pension liabilities with financial assets. For starters, you can’t hedge the actuarial risks around participant behavior and people living longer. The sponsor must bear these costs through increased returns or contributions.
Additionally, the fixed income portfolios that are used to hedge liabilities will experience downgrades and defaults. The liabilities won’t change, but there will be performance drag across time. A more diversified stabilization strategy can still out-earn the liabilities over the long run and that drag from credit losses will just be noise. But when assets are concentrated in fixed income, the drag becomes more difficult to outrun. This is the critical flaw in most hibernation strategies. An LDI portfolio comprised of long-duration corporate bonds and Treasuries will slowly burn through its excess capital.
How might pensions approach additional de-risking now?
We really need to get away from the notion that, as the hedge portfolio grows in size it should become more and more concentrated in corporate credit. The exact opposite is true. Hedge portfolios need to become more diversified. Treasuries certainly have a role to play, though their lack of yield is a concern. Long-duration, securitized fixed income and high yield bonds are also useful options, but the list doesn’t end there. It’s instructive to observe the investing behavior of life insurance companies, who are managing the risks of annuity portfolios that are quite similar to pension liabilities; these firms are large holders of securitized assets, crossover portfolios that incorporate high yield bonds, structured credit and mezzanine debt.
The other path to de-risking begins in the return-seeking portfolio. Investors today have access to a far more diverse set of low-to-moderate volatility alternative asset classes that can deliver stable excess performance versus liabilities without the high volatility and low correlation of equities. Many of these asset classes are also capable of delivering a high level of distributable income, which is a valuable resource for a benefit-paying institution.
Defined benefit plans are continuing to decrease as defined contribution plans become more common. Do you see a future for DB plans?
I hope so. The historical volatility of defined benefit pensions and the uncertainty surrounding contributions convinced many sponsors that they were too risky to maintain. This is simply untrue. A well-funded and prudently managed DB plan has powerful benefits that a DC plan simply cannot replicate. When we consider the recovery in DB plan funding and the evolution of pension asset allocation over the past 20 years, there should be a conversation in corporate America about preserving what remains of the DB system. While I am not convinced we will see closed plans reopen or new plans created, it’s worth considering. In a period of rising wages and highly competitive labor markets, the original purpose of defined benefit plans comes back into focus: proving a tax-advantaged, investment-driven vehicle for delivering competitive benefits to employees.
What is the next evolution in pension plan strategy?
I would love to see pension stabilization evolve to become the standard model. I’m encouraged because I do see many well-funded plans adopting elements of this approach. Consultants are getting behind this trend as well, although some continue to view the pieces independently rather than as a holistic framework that can challenge the glide path/hibernation/termination model.
I think we may be close to the high-water mark for traditional LDI strategies. With current interest rates and credit spreads, managers know that a dollar put into a traditional LDI strategy today is almost never going to outperform liabilities going forward. Conditions may change, but from where we stand today, it’s hard to envision those LDI frameworks remaining static. There are just too many better ways develop a risk-efficient pension strategy outside of them.
What do you see as the advantage for plan sponsors in the way JP Morgan collaborates with them on pension stabilization?
JP Morgan has a 150-year history of serving as a fiduciary to our clients; I can’t overstate the importance of that legacy to the present-day JP Morgan Asset Management. We also have the broadest cross-section of investment strategies of any manager in the business, each of which is built around the premise that highly skilled, independent investment teams can deliver specialized strategies while drawing on the collective resources of the broader organization. Unlike some firms that implictly guide clients to the particular strategy in which they specialize, we want clients to make the best possible strategic decision because we are confident that we will find a way to partner with them in implementing it.
With respect to pension stabilization, the merits of the approach speak for themselves. As clients look to implement this type of program, they will need to reconsider their exposures to traditional hedging and return-generating assets as well as new forms of diversifiers. For hedge portfolios, we’ve been at the forefront of long-duration securitized investing and have a long history of success in high yield and mezzanine debt. Within the realm of alternative diversifiers, we tend to highlight the powerful income generation and diversification benefits of core real assets – with a very strong platform across real estate, infrastructure, and transportation.
JP Morgan also has a long history of working with institutional clients in discretionary management and delegated solutions. Pension plans may not have the internal resources and operational flexibility to execute a sophisticated asset allocation that takes advantage of the full investment opportunity set. A number of sponsors are currently using our delegated platform and its full spectrum of assets to outperform liabilities in a risk-aware manner, and we think this business model will continue to grow.
The current path to hibernation and termination is a dead end. Specialized LDI managers aren’t going to give plan sponsors the unbiased advice that they need. Diverse, forward-thinking managers and consultants can help redirect clients to change course with full-spectrum strategies that maintain positive returns while still managing volatility. We want plans to get fully funded and stay fully funded. Pension stabilization can achieve both and help ensure their pensions are once again able to be a source of value.