Corporate pension funds in the U.S. that are unable to match their liabilities to corporate bonds are increasingly looking at structured products and Treasury securities for that purpose. Separate Trading of Registered Treasury Bond Interest and Principal Securities (STRIPS), swaps and swaptions are generating more interest among plan sponsors and stand to garner even more attention in the event yield curves get steeper.
STRIPS are Treasury bonds in which the principal has been separated from the interest. STRIPS only pay off when the bond matures, so investors know exactly how much they’ll make from an investment. Likewise, swaps—derivatives where counterparties trade flows from one asset for those of another—and swaptions—options giving the owner the right to enter a swap agreement—also give funds the ability to precisely match the duration of their liabilities to their assets.
Liability-driven investing seeks to reduce the volatility of a plan’s funded status. Plan sponsors have commonly reduced their allocations to equities and invested in long-duration fixed income in order to better link assets to liabilities. These days, however, STRIPS, interest-rates swaps or swaptions in many cases are providing duration exposure at the very long end of the yield curve, i.e. 20 years or more, which isn’t available in the corporate bond market.
Funds often seek investments in longer durations as a means to match their liabilities over time, said Scott Whalen, executive v.p. at Los Angeles-based Wurts & Associates. Chris Levell, a partner at Cambridge, Mass., consultant NEPC, noted that although investment in long-duration corporate credit tends to be the more typical means of implementing the strategy, the resulting hedge is not meaningful for clients that typically want to get a very long duration. He cited STRIPS’ 20-30 year duration and the 20-year horizons of swaps and overlay futures.
Martin Jaugietis, head of LDI solutions at Seattle-based Russell Investments, said that of the roughly 75% of its corporate defined benefit clients that have adopted some form of LDI, as many as 20% use STRIPS, swaps or swaptions.
Funding Frenzy
The shift toward structured financial products comes as funds find themselves on the funding ropes. Data compiled by Seattle, Wash.-based Milliman show deficits at the top 100 U.S. corporate defined-benefit schemes increased to $464.4 billion at the end of 2011 from $228 billion at the end of 2010. Earnings have largely kept plans’ funded status stable at 87% until June. Six months of wretched returns, however, pushed funded status to 74.2%.
As if chronic underfunding weren’t enough of a problem, plan sponsors are now concerned that their poor funded status could negatively impact how analysts rate their companies. Of 192 senior finance professionals surveyed by Chicago-based Mercer recently, 52% said equity analysts and investors are at least moderately scrutinizing their company’s pension fund and its effect on the company’s overall financial health.
Jonathan Barry, defined benefit risk leader for Mercer’s U.S. Retirement Risk and Finance business, said the shift is due to pension deficits being viewed in the same way as corporate debt. He noted that if a company’s pension obligation is a significant percentage of a company’s overall market capitalization, there’s a chance ratings agencies may become concerned about how the deficit will affect a company’s ability to pay down existing debt or grow in the future. But there’s little evidence of impact so far. “I can’t imagine ratings for a company with a market cap of $500 million more being particularly impacted by the status of its pension fund,” Barry said.
Consultants say ratings firms should be keeping a close eye on corporate funded status if cash contributions to an underfunded plan impact the company’s ability to service debt. “To the extent corporations target certain leverage ratios for the overall balance sheet, the underfunded status will have an impact on their credit rating,” said Soonyong Park, managing director and head of global portfolio solutions for Darien, Conn.-based RogersCasey, noting the current low-interest rate environment has prompted some companies to issue debt to cover their underfunded plans.
Moving LDI Forward
Though liability-driven investing remains a popular solution for corporate schemes, consultants differ on how to implement the strategy. Mercer’s Barry noted funds gradual derisking tends to be the preferred means of moving to a liability-driven investment strategy. Levell, however, said funds shouldn’t muddy the waters.
“One of the things we say to our clients is that we believe pursuing LDI strategies requires a change in mindset,” he said. “We’re not big fans of doing it a little bit, because increasing assets towards liabilities results in increased volatility of asset returns and doesn’t really change the volatility of the plans funded status. The endgame should be a material change in how we view the plan.”
“There’s no black-and-white in terms of being in LDI or not,” said Jaugietis, who added the majority of Russell’s corporate clients still have over half of their portfolios invested in return-seeking assets because they’re underfunded. “One, through an LDI approach, may invest in long-duration bonds or bonds of different types and still have significant return-seeking allocations.”