Pension Volatility Is Back ... (And It's Not My Fault!)
By Mike Clark, Consulting Actuary, the Principal Financial Group
In my January 24 blog, Market bull beats liability bear by a nose in 2017, I made a thoroughly actuarial comment that a liability driven investment (LDI) strategy can protect defined benefit (DB) plans against the risk of net loss in times of uncertainty. It seemed like a quaint thought at the time as market volatility had been on hiatus for almost two years.
Then, seemingly on cue, equity markets immediately cratered. The S&P 500 shed 10 percent between January 26 and February 8, technically satisfying the definition of a market correction.
Experts confirmed the slide was caused by concerns about inflation, and nothing directly attributable to any of my comments. (i.e., It's not my fault!)
Free pass?
A typical traditionally invested DB plan - say 60 percent equity and 40 percent core bonds - lost 2 to 3 percent on their funding ratio in those two weeks. This temporarily erased all the gains for the entire year of 2017.
Fortunately, markets have since regained their footing and corporate bond rates have risen, so the net impact of this turbulence has been relatively slight. Consider it a learning opportunity - a free refresher course on volatility without permanent damage to funding ratios.
Reconsidering LDI
Expectation of rising interest rates is often cited as a reason to postpone implementing an LDI strategy. (This is because shorter duration bonds generate positive net returns against pension liabilities when rates rise.) Hesitancy to exit a one-directional bull market is another.
These are certainly valid thoughts, particularly for underfunded plans. But if the correction indeed signals the dawn of a new era, one of rising rates and increased equity volatility, LDI may be worth another look.
Managing two risks
The move from a traditional to an LDI allocation really consists of these two decisions for sponsors and advisors:
- When to reduce equity risk?
- When to extend fixed income duration to reduce interest rate risk.
The answers to these questions will vary based on plan sponsor financial strength, economic outlook and funded status. Regular funded status updates are critical in constructing LDI glide paths and timing allocation changes. [Blog: Rime of the dynamic asset allocation mariner]
Reducing volatility with LDI
If the correction of 2018 is indeed the first tremor in a series of shocks to come, sponsors may want to reconsider their risk appetite under this potential new paradigm.
We don't know when the next correction (which also won't be my fault) will occur, but it is bound to happen someday. Since we have no idea of knowing exactly when that may be, I will leave you with one last thoroughly actuarial thought:
A well-executed LDI strategy can significantly reduce the risk of negative net returns regardless of what equity markets or interest rates decide to do.
Mike Clark is a fellow of the Society of Actuaries (SOA) and member of the American Academy of Actuaries (AAA), and is very sorry if it turns out this all actually is his fault.
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