Despite the dramatic market recovery witnessed since late March, market values remain down from their previous highs in many asset classes. The unprecedented environment institutional investors find themselves in has been exacerbated by stubbornly low or negative sovereign bond yields, encouraging many plan sponsors to consider more imaginative methods of sourcing income and maintaining sufficiently high rates of return without materially increasing the risk of a loss of capital. More than ever, investors need new ways of thinking to build more resilient portfolios.
These challenges perhaps explain why pension plan sponsors are increasingly paying attention to liability-driven investing (LDI)—an investment framework that uses a pension plan’s liabilities, in place of public market indexes, as the benchmark against which it measures investment performance. LDI solutions allow for a tailor-made approach in managing fixed-income assets against pension liabilities while also taking advantage of dynamic glide path strategies to help better frame asset allocation decisions. We believe implementing an LDI framework can help plan sponsors of all sizes better manage funded status volatility. And while some plans sponsors might prefer to wait for interest rates to rise before moving forward, we firmly believe inaction could be costly.
Rethinking the benchmark
The underlying rationale for LDI is relatively straightforward: Most risk-based financial markets move to their own rhythm, basically independent of a plan’s obligations. It’s therefore difficult for a plan that benchmarks its portfolio against a public market index to expect to match its specific liabilities in a consistent and reliable manner. Selecting an appropriate benchmark is critical for plan sponsors because the economic risk profile of a market index can be quite different from a pension plan’s liability risk profile. With this in mind, an LDI framework is built around the concept of liability matching.
When implementing LDI, a plan would typically split its portfolio into two parts:
1 Hedging portfolio—A hedging portion that closely matches a plan’s liabilities, typically comprising fixed-income instruments as well as other income-generating assets
2 Growth portfolio—A return-seeking portion that’s typically not very correlated to the plan’s liabilities, but could help to narrow any gap in a plan’s funded status
This year’s market drawdown provided a prime example of how LDI strategies can build resilience into portfolios. We compared the performance of varying asset mixes from a traditional balanced 60% equity/40% fixed income mix to a 20% equity/80% LDI portfolio across several markets. Plans using an LDI approach, and that began the year fully funded, saw their funded level fall between just 3-5 percentage points to the end of March, while those using a traditional balanced allocation suffered potential declines of up to 16 percentage points.¹ Such a dramatic fall could have had a significant impact on a plan sponsor’s need to make necessary contributions and perhaps even threaten the financial viability of a plan sponsor also adversely effected by the COVID-19 crisis.
A dynamic approach to de-risking
Typically, a plan begins the de-risking process by determining the proportion of liabilities that needs to be hedged, thereby establishing the hedge ratio, with the remaining assets invested in a diversified portfolio of return-generating growth assets. A dynamic asset allocation framework gives sponsors the flexibility to adjust their allocation between the hedging portfolio and the growth portfolio over time.
To help them decide precisely when they should adjust their allocation between the two portfolios, many plans have chosen to adopt a de-risking glide path. In its simplest form, the de-risking glide path maps out when a plan should increase allocation to its hedging portfolio as different conditions are met on its path toward fully funded status.
A key advantage of a dynamic asset allocation framework is that it allows plans to lock in the gains extracted from the growth portfolio by transferring them to the hedging portfolio as they’re realized. An additional potential benefit is that as sponsors make additional contributions to the plan, its funded ratio improves. This means that any additional contributions will generally be invested less aggressively than they might be without a glide path in place.
Depending on the parameters agreed on when implementing the glide path, pension plans can also control the speed of de-risking and the sources of risk they’re willing to accept within their return-seeking growth portfolio.
Traditional asset allocation versus dynamic asset allocation²
By way of example, let’s take a pension plan with an initial funded ratio of 90% that’s allocated 40% of its assets to its hedging portfolio and allocated the rest into growth asset classes. Let’s also assume that the plan’s sponsor has adopted the dynamic asset allocation strategy and decided to increase its liability hedge ratio by 2% for every 1% increase in its funded ratio.
According to our calculation, the plan would have experienced much lower funding ratio volatility if it had adopted the dynamic asset allocation framework. Over the course of the last 10 years, the difference between the highest and lowest points of the plan’s funding ratio would be around 15%, as opposed to more than 25% if it had gone with the traditional allocation strategy. This is because the dynamic allocation approach allows the plan to lower its exposure to risk as gains are made in the growth portion of the fund.
Our study shows that, over time, the plan’s hedge ratio should progress in a relatively smooth manner toward its targeted funding level under the dynamic asset allocation framework. By contrast, the plan’s hedge ratio would have simply moved in line with the market if it had adopted the traditional approach. The impact of this additional funded status volatility is increased volatility of contributions.
Enhancing returns and managing risk with real assets
With expected returns across global bond markets so low, relying solely on bonds for hedging has become extremely challenging. The 10-year U.S. Treasury note currently yields a nominal 0.5%, with other high-quality government bonds offering even less: Comparable issues from Canada, yielding 0.4%, Japan, yielding 0.0%, and Germany, yielding negative 0.5%, appear unlikely to live up to their historical levels of income generation.³ In fact, our global chief economist expects major central banks to keep policy rates at or below zero until at least 2025, “a development that could push investors further out on the risk spectrum, swapping traditional government bonds for higher-yielding alternative assets.”⁴
It’s perhaps natural that plan sponsors may cite low interest rates as a reason to delay implementing de-risking strategies. However, by choosing to wait for interest rates to rise, sponsors would have—by default—chosen to embrace equity risk as well as interest-rate risk.
One way of mitigating this risk is for sponsors to consider allocating a portion of their hedging portfolio to a diversified set of asset classes that are complementary in nature to their fixed-income portfolio. Assets that we believe could fit the bill include real estate, infrastructure, timber, agriculture, mortgages, and alternative assets. Ideally, these assets should have a low correlation to those held in the growth portfolio. The goal is to create a diversified hedging portfolio that’s aligned with a plan’s obligations.
LDI: an evolving framework
Plan sponsors of all sizes can now choose from a range of de-risking solutions based on their individual needs. What’s perhaps most important for sponsors is deciding to take that first step.
The risk of waiting for the right time is that a plan’s funded status could deteriorate further if turbulence continues. In our view, while we may be hard-pressed to define what could be considered the perfect moment to implement LDI or de-risking strategies, there is no wrong time to draw up a plan for the future.
1 Wall Street Journal, YCharts, Manulife Investment Management, April 20, 2020. 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 Traditional strategy is rebalanced monthly to target allocation. Dynamic allocation strategy is rebalanced monthly to achieve a dynamic target hedge ratio. 4 “The three stages of the global economic recovery,” Manulife Investment Management, July 24, 2020.
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 preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material, intended for the exclusive use by the recipients who are allowable to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication and are subject to change based on market and other conditions. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers, or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment, or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer, or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against a loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams, along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
These materials have not been reviewed by and are not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional.
Australia: Hancock Natural Resource Group Australasia Pty Limited, Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area and United Kingdom: Manulife Investment Management (Europe) Ltd., which is authorized and regulated by the Financial Conduct Authority; Manulife Investment Management (Ireland) Ltd., which is authorized and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad (formerly known as Manulife Asset Management Services Berhad) 200801033087 (834424-U). Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G). South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC, and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.
Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates, under license.