Under an LDI strategy, sponsorsrelegate assets to 2 buckets: 1 seeks protection by matchingliabilities to fixed-income strategies; the 2nd looks to capturegrowth through equities. But simply moving away from equities isproving not enough. (Photo: Shutterstock)

All-time low discount rates that determine the cost of adefined benefit plan's liabilities, along withequity market volatility, are forcing more sponsors to re-examinethe risk component 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.

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

Plan liabilities increased by $82 billion, thanks to decliningdiscount rates. From the end of September 2018 to the end ofSeptember this year, the discount rate sank from 4.18 percent to3.09 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 sponsors are feeling the pinch in anera 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 to 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 not enough toprotect assets. Nor is deploying a pure passive strategy within thegrowth bucket. A recent State Street survey showed nearly half ofU.S. institutional investors say active equity strategies are thehedge to offsetting low-interest rates and market volatility.

"Corporations are realizing that ignoring the risk focus oftheir risk buckets is dangerous," said Engel. "The punch line isyou 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 the conventional wisdom that equities should onlyserve a growth purpose," said Engel. "But there is no reason whyyou can't put a dual objective on your equity bucket."

Of course, what constitutes a defensive equity strategy is opento interpretation.

At State Street, the objective is to deliver lower volatilitythan benchmark indices, while capturing higher returns, explainedEngel.

There is a catch, she concedes.

"Some plans judge risk buckets on how they track with benchmarkstrategies. But if you are looking for a return stream in equitiesthat also lowers volatility, you have to accept some tracking errorrisk," said Engel.

"If you are solely worried about underperforming an index, youcan't build a portfolio that will reduce risk, and ultimatelyimprove returns," she added.

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 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."

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