In the second article in a series, Pascal Blanqué and Amin Rajan outline the intricacies of managing a defined benefit pension plan in the run-off phase
- COVID-19 has made a bad situation worse for pension plans
- There are no simple options in coping with it, only trade-offs
- Narratives more than fundamentals are set to drive capital markets
Faced with a once-in-a-100-year event, central banks did what they had to do when the pandemic hit the global economy – they pushed interest rates zero bound to avert a 1929-style depression. But this accentuated two unintended effects on pension finances.
Income, which funds the regular pay-outs, has fallen while liabilities have soared.
To cover the resulting shortfall, plans have had to invest even more or hold fire sales of their current assets. To make matters worse, lockdowns forced many plan sponsors to defer their deficit repair contributions and request ‘pension holidays’, while posting profit warnings during the lockdowns.
Unsurprisingly, therefore, 48% of our survey respondents report that the impact of the pandemic on the financial viability of their plan has been negative, while only 6% think it has been positive. Similarly, 39% report a negative impact on the overall funding ratio, while none report it as positive; and 46% report a negative impact on cash flow for paying regular pensions, while 9% report a positive impact.
About the only area where a net positive impact is evident is in the portfolio of risky assets. As the post-pandemic market bounce turned into the mother of all rallies in 2020, 38% reported a positive impact and only 3% reported a negative impact.
However, the bounce was not felt more widely, since ageing demographics have been pushing many plans into de-risking mode via bond investing during the past two decades, in line with the regulatory requirement in all pension markets.
Apart from missing juicy equity returns, the overweight positions in bonds have also created their own interest rate risk. With the recent recovery in the global economy, the fear is that another toxic mix of rising rates and rising inflation will badly hit fixed-income assets – around 60% of the portfolio on average – and force them to bear more risk just when asset prices bear no relation to reality.
Re-risking and de-risking
With ageing demographics, capital preservation has become a top priority to meet the pension commitment. And with asset values reaching a new plateau, the sequence of returns risk is always lurking in the background – the time taken for a portfolio to recover after a big drawdown.
Hence, the principal risk metric now is the likelihood of the permanent impairment of capital. This metric is all the more pertinent with the current state of funding ratios. Only 38% of our respondents have a ratio above the statutory requirement of 100% in most pension markets that enables them to honour the pension promise. At the other extreme, 30% have a ratio below 90%.
To bridge the gap, the annual returns net of fees required in their portfolios vary. 61% need less than 5%; 24% need 5-7% and the remaining 15% need over 7%.
These targets may well prove challenging as equity markets continue to flirt with their all-time highs after central bank actions have once again borrowed against future returns.
They are equally challenging against the reality of the current cash flow status of individual plans: 33% report positive cash flow; 19% report neutral status; and 48% report negative status – as shown in our report.
Thus, pension plans are relying on two avenues to improve their funding ratios.
On the non-investment side, they are adopting various solutions. More immediately, the focus is on seeking further cash injections from their sponsors and extending the recovery period to give them more time to plug deficits. For the longer term, they are implementing structural changes like closing down DB plans and/or reducing benefit levels.
On the investment side, they are increasing allocations to riskier assets that could potentially deliver higher returns. This is counterintuitive from the perspective of the end game, as envisaged by regulators who worry that risk does not always generate returns, especially while markets are so distorted by central bank action.
Regulators require mature plans to have a low level of reliance on their sponsors and choose assets with high resilience to risk. After all, asset class returns and correlations have become time varying. Currently, going into risky assets is not the best option for some plans. But it is their only choice. This is not how the end game was meant to be. It couldn’t have come at a worse time.
Thus, a toxic mix of regulation, ageing demographics and low rates has pushed the majority of defined benefit plans into a catch-22 situation: they can’t afford to take a risk with rising deficits in a maturing plan; nor can they cut deficits without taking risk. Indeed, 32% of our respondents expect to increase risk; 41% expect to decrease it; and the remaining 27% to leave it static (figure 1, left chart).
Some 31% also report that greater risk taking will conflict with meeting their plans’ funding goals to a large extent, with a further 47% reporting it to some extent (figure 1, right chart) – particularly as risk-taking in the end game is a high-wire act.
Targeting multiple investment goals
Given the agnostic need to earn decent returns in the face of funding deficits, our survey respondents are left to strike a balance between three conflicting aims in their end game – generating returns to improve the funding ratio, reducing risk relative to liabilities, and having rising cash flows as ever more members retire. That means dividing their portfolios into three asset buckets (figure 2).
Equities dominate the return seeking bucket. They provide extra returns to act as a buffer against any emerging risks. Tactical asset allocation, too, is there to earn alpha, since both the nature of asset class correlations and their risk premia have become time varying, creating fleeting return opportunities.
At the other extreme, bonds dominate hedging assets to serve three aims. First, conserve capital in case the global economy tips back into secular stagnation after a one-time recovery from the big policy stimulus in 2020.
Second, provide collateral for hedges against a key unrewarded risk: rising interest rates. Third, deliver cash flows via a wide range of short-dated high-quality investment-grade public corporate bonds that match liabilities on a rolling basis, as a part of cash flow-driven investing (CDI).
In between are cross-over assets, with equity-like returns and bond-like features. They are also included in CDI, given their more predictable cash flows and/or terminal values – like high-quality equities, real estate and infrastructure – and are also used to match shorter tranches of liabilities.
Because of the relative dormancy of inflation over the past 35 years, it is unclear which asset classes provide the best hedge. The challenge is to hedge with a mix of assets that achieve one or more of three goals: have a high correlation to inflation in the short term; have the potential to generate returns that are greater than inflation over time; and have the in-built attributes that can cope with unexpected inflation.
For now, the focus is on equities, commodities and private market assets – like private debt, real estate and infrastructure – where inflation protection can be hardwired into asset mandates.
However, a big concern is that inflation and rising rates could hit hedging assets just when they are needed to de-risk the equities that target high returns.
As portfolio ballast, bonds now have limited capacity to make up for stock market losses in a downturn. They are also more vulnerable to rapid sell-off if inflation gathers pace.
Thus, hedging assets and cross-over assets are becoming the main vehicles for CDI as plans advance towards their end game. This is easier said than done.
This is because ageing demographics have raised the primacy of cash flows. And zero-bound rates have made them hard to secure. Only time will tell if CDI will solve this conundrum.
Thus, pension obligations are maturing against a most inopportune macro-economic backdrop. In asset choices, therefore, there are no simple options, only trade-offs. As a result, narratives are becoming the guiding stars.
Relying on narratives
With the market meltdown in March 2020, the traditional risk–reward relationship was turned on its head. Stocks from the technology and pharmaceutical sectors, for example, once used to amplify market movements, rose even higher when the market went up and fell even further when it declined. But in the COVID-19 market, they experienced lower volatility. At the same time, stocks that previously exhibited a dampening effect, such as defensive and mining stocks, and lagged a spiking or declining market now have sharper ups and downs.
The implication is that stocks from low-volatility sectors can actually increase risk. One argument why stocks may not be as expensive as they seem is that interest rates are extremely low. But low rates usually presage a recession that could hit corporate earnings.
Contradictions like these abound in the absence of a historical precedent for reopening after a global pandemic. So narratives based on long-term expectations are more likely to drive markets than fundamentals. Hence, pension plans and their asset managers are now planning for three plausible yet conflicting narratives about the markets over the next 3-5 years.
The first envisages that, after the sugar highs from an unprecedented level of policy stimulus in 2020, secular stagnation will return, pushing the global economy into its old low-growth/low-inflation/rising inequalities funk.
The second narrative envisages that stimulus will boost growth and the resulting inflation will drive interest rates into positive territory and allow governments to take long-overdue action to tackle mounting inequalities.
The third suggests that we move into a full-blown world of inflation, last experienced in the 1970s. Just as inflation reached a point that could no longer be tolerated four decades ago, so weak growth and inequality can no longer be tolerated now.
Refining the manager selection criteria
In the light of the foregoing challenges, manager selection is no longer mostly about fees and past performance. Pension plans expect their asset managers to bring a number of capabilities to the table. To start with, they need to have a deep understanding of their clients’ risk appetite, weakening sponsor covenant and balance sheet issues as they approach the end game.
Furthermore, plans need tactical asset allocation in the beta space as a source of incremental value by selecting managers who are experts in granular factor exposures that capture the shifting nuances of the unusual policy response to COVID-19. They need alpha returns with performance fees that offer an equitable sharing of pain and gain.
Finally, asset managers need a deeper understanding of which of the narratives will play out and their associated value traps and value opportunities, while there remains a big disconnect between capital markets and the real economy.
Pascal Blanqué is group CIO of Amundi Asset Management and Amin Rajan is CEO of CREATE-Research. Both are members of the 300 Club