All-time low discount rates used to determine defined-benefit(DB) pension plans' liabilities, along with equity marketvolatility, are forcing more plan sponsors to re-examine the riskcomponent in liability-driven investment (LDI) managementstrategies.

The aggregate funded deficit of the 100 largest corporatedefined-benefit plans expanded by $64 billion in the third quarterof 2019, despite an $18 billion increase in the value of planassets, according to Milliman's Pension Funding Index. Planliabilities increased by $82 billion, thanks to declining discountrates. From the end of September 2018 to the end of September thisyear, the discount rate sank from 4.18 percent to 3.09 percent.

The funded ratio of the largest 100 plans fell from 94.2 percentto 85.4 percent over the year. By comparison, the discount rate was7.63 percent in 1999, a time when larger pensions were running anaggregate funding surplus, according to Milliman.

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

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

"Funded status has not really improved. Market volatility iscontributing to sponsors' concern and nervousness about the statusof 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 toprotection mode, explained Engel.

That means reducing equity exposure in the effort to protect thecoffers. Over time, large pensions have shifted an increasingamount of assets from equity to fixed income. In 2018, the averageequity exposure in large pensions was just over 30 percent,compared with more than 60 percent in 2005, according to Milliman'sdata.

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

But simply moving away from equities is proving to not be enoughto protect assets. Nor is deploying a pure passive strategy withinthe growth bucket. A recent State Street survey showed that nearlyhalf of U.S. institutional investors say active equity strategiesare the hedge to offsetting low interest rates and marketvolatility.

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

Getting Defensive with the Equity Sleeve

A defensive equity strategy carries such a dual mandate: Itseeks returns with a balance of managing risk. "It challenges theconventional wisdom that equities should only serve a growthpurpose," said Engel. "But there is no reason why you can't put adual objective on your equity bucket."

Of course, what constitutes a defensive equity strategy is opento interpretation. At State Street, the objective is to deliverlower volatility than benchmark indices, while capturing higherreturns, explained Engel.

There is a catch, she concedes. "Some plans judge risk bucketson how they track with benchmark strategies. But if you are lookingfor a return stream in equities that also lowers volatility, youhave to accept some tracking error risk," said Engel. "If you aresolely worried about underperforming an index, you can't build aportfolio that will reduce risk and ultimately improve returns,"she added.

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

A defensive strategy uses empirical data to measure returnsagainst units of risk with the objective of generating returns inup and down markets. That portfolio will look different than abenchmark index.

"Where it would lag an index is in the short run, in anenvironment where there is an equity rally after a time ofdecline—a defensive strategy may not keep up in that market," saidEngel.

That global markets have already entered a period of increasedmarket volatility—the so-called "beta bubble" of the past decade isprimed to burst—is a sentiment shared among many institutionalinvestors. A State Street survey of 400 institutional investorsshows their main concern is heightened risk in capital markets.

But what if that sentiment proves wrong? What if trade disputesare resolved, global growth resuscitates, the American consumerremains strong and realizes further wage growth, and inflationremains in check? What if there is a breakout rally that extendsthe historical bull market for another two years? Or fiveyears?

Would pension sponsors then regret a defensive strategy?

"If lagging a high-beta–fueled equity rally is your concern, youwould still be okay," said Engel. "If the worst-case scenario isyou 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 higherreturns."

From: BenefitsPro