LDI in 2023: Ten questions corporate plan sponsors are asking

Our LDI Team offers insights for the coming year, addressing some commonly asked questions on funded ratios, intermediate credit, alternatives, cash-balance plans, and other return-seeking and liability-hedging topics. 

1. What’s the state of funded ratios and derisking activity, as well as return on asset (ROA) assumptions?

Jacqueline Yang: In 2022, US corporate defined benefit (DB) plans in aggregate found themselves with the strongest funded ratios since prior to the global financial crisis, as the reduction in liabilities arising from higher discount rates eclipsed the losses in equities and other assets — although funded ratios did lose some ground in December as rates retreated and equities fell again. The aggregate funded ratio for US plans was about 102% as of 30 December 2022, up from 95% at the end of 2021 but off a peak of about 105% in mid-November.¹

Strong funded ratios drove some derisking activity and may lead to more in 2023 — particularly, in our estimation, if plans reach and sustain a 105% funded level. Of course, individual plan experiences will vary, especially for plans with high fixed income allocations and liability-hedge ratios, as they haven’t benefited as much from higher discount rates.

In terms of ROAs, we saw assumptions continue to decline gradually through 2021, though we would note that higher capital market return assumptions — a result of lower asset valuations and higher yields — may cause this trend to reverse in 2022 reporting. We provide more detail, including our long-term capital market assumptions, in our 2023 ROA guide. 

2. What are the key pension accounting and funding issues to watch in 2023?

Amy Trainor: I would highlight a couple of issues that I think plan sponsors should be aware of:

Higher pension expense — Despite recent improvements in funded status, we think many plans may face higher pension expense (or lower pension income) in fiscal 2023 due to higher discount rates. While higher rates were the primary driver behind stronger funded ratios in 2022, they may also lead to higher interest cost (discount rate times projected benefit obligation [PBO], adjusted for benefit payments) in the 2023 pension expense calculation. In addition, plans that use a “full yield curve” methodology for developing their interest cost may face additional headwinds from the flattening in the curve over the course of 2022, as near-term liabilities, which have a greater weight under this method, will be multiplied by an even higher interest rate.

Potential for an end to contribution holidays — Sponsors who had projected extended contribution holidays based on comfortable surplus positions may find themselves making minimum required contributions sooner than expected. Based on year-to-date asset returns and interest rates through year-end 2022, we estimate that the average Pension Protection Act (PPA) funded ratio, which governs minimum funding requirements, is tracking between 105% and 110% for the 2023 plan year, a significant drop compared to our estimate of 137% for 2022. 

As background, the calculation of the PPA target liability discounts cash flows using a modified high-quality corporate bond yield curve (averaged over 24 months) to derive what are called “segment rates.” In 2012, Congress introduced “stabilization” provisions that limit the PPA segment rates to a corridor, currently 95% – 105% of their 25-year historical average. Since the corridor was implemented, the lower bound, or floor, has consistently applied, as the downward trend in interest rates has kept market rates below their historical rolling average. In other words, for the last decade, plans have used an above-market discount rate to measure their minimum funding liability.

Furthermore, the corridor is generally unresponsive to changes in market rates, given that it is based on a long-term historical average. As such, the PPA liability is projected to barely budge between 2022 and 2023. At the same time, we estimate assets have lost 15% – 20% from the concurrent sell-off in equities and bonds, putting downward pressure on PPA funded ratios. This stands in contrast to the GAAP funded ratio, where rising market-based discount rates have offset asset losses and contributed to funded-ratio improvement for many plans. 

3. What are the potential LDI implications of these pension accounting and funding issues?

Amy Trainor: On a mark-to-market discount rate basis, such as under US GAAP, returns in the liability-hedging portfolio are — by design — intended to match changes in the plan’s liability, keeping funded ratios stable whether rates rise or fall. But under PPA rules, such liability matching won’t occur outside of the narrow corridor, and a continued rise in rates could be detrimental to PPA funded ratios. Does this mean plans should abandon LDI in favor of a total return investment strategy or reduce their hedge ratios? I offer some thoughts, though plans should consult with their actuarial or legal professionals about their specific situations:

• Prioritize financial objectives and understand trade-offs: For sponsors primarily concerned about managing balance-sheet volatility or the impact of the PBGC variable rate premium calculation (to which the stabilization corridor does not apply), it may be more important to match liabilities despite the disconnect with the PPA rate. Sponsors that prioritize cash-funding requirements but have low GAAP balance-sheet sensitivity may opt for less of a liability-hedging emphasis.
• Consult with your actuary on PPA discount-rate elections: Plans emphasizing LDI in their asset allocation may want to consider using the market-based, unaveraged, full yield curve under PPA, provided they consult with their actuary to understand all related implications and restrictions.
• Take a long-term view on contributions: It may be cold comfort, but plan sponsors generally under-contributed over the last decade relative to GAAP (mark-to-market) funded status.
• Define the role of hedging assets: Conduct scenario analysis, including a classic recession scenario (rates down, negative equity return).
• Consider defensive equities and interest-rate-sensitive return-seeking strategies: For plans that decide to reduce hedge ratios in response to PPA dynamics, having more downside mitigation and interest-rate-sensitive strategies (such as infrastructure, real estate, or return-seeking fixed income) alongside core equities may take on greater importance.

You can read more on these topics in our paper: Setting ROAs for 2023: A guide for US corporate and public plans.

4. Does the recent UK liquidity crisis suggest that US plans should abandon interest-rate (IR) derivatives?

Amy Trainor: I don’t think so. If sized appropriately, exposure to IR derivatives may offer a variety of potential benefits. For example, among plans needing return-seeking exposure, using IR derivatives to increase the liability-hedge ratio may help reduce funded-ratio volatility and limit downside exposure in a classic recession (when rates fall).

That said, in some cases, US plans may realize similar advantages to synthetic duration by extending duration using physical bonds such as long Treasuries and long STRIPS. In fact, physicals may be prioritized over synthetics given the former’s lower costs and because losses do not need to be realized as they do for synthetic instruments. After maximizing duration via physicals, plans may elect to extend duration further via synthetics. In sizing the notional exposure, I think plans should consider:

• The potential benefits, such as the projected reduction in funded-ratio volatility
• The transaction costs to roll futures quarterly or to hold swaps (swap spread)
• The potential impact of a liquidity stress event (e.g., how much collateral would need to be raised if rates rose by a given amount?). In addition, those plans that also source equity exposure synthetically will want to keep changing equity/bond correlations in mind.
• Building in potential safeguards, such as using “funded overlays” that include both physical and synthetic exposures so that the manager can readily access liquidity, and capping the amount of unfunded duration.

Lastly, as plans advance along their glidepath and add to the liability-hedging bucket, I think they should consider reevaluating how much unfunded exposure is needed and whether there is an opportunity to scale back.

5. There appears to be growing interest in intermediate credit. What do DB plans need to know about this asset class?

Connor Fitzgerald: As noted earlier, we could see more money moving from return-seeking allocations into liability-hedging allocations in 2023. For plans reaching the next derisking trigger, intermediate credit could play a key role — either because a plan is closed and its duration is declining every year or because it has a large liability-hedging allocation and no longer needs capital-efficient sources of duration and spread duration to hedge liabilities. This could favor intermediate credit flows and support the market from a technical perspective.

There are some key differences between the intermediate (1 – 10-year maturities) and long-duration (10+ year maturities) segments of the investment-grade market. For example, the intermediate segment of the market is significantly larger and more liquid than the long end. In addition, intermediate indices have a much larger allocation to the financial sector than long indices. With this in mind, plans might want to establish benchmark-relative industry limits across intermediate and long-duration portfolios, as opposed to absolute limits. Absolute sector limits (e.g., limiting financial sector exposure to 35%) can be more restrictive in an intermediate portfolio given the concentrated nature of the market in certain industries, which can limit a manager’s ability to express active views on the attractiveness of different industries.

It’s also worth noting that unlike corporate indices, credit indices have allocations to the government-related sector, including taxable municipals, sovereigns, and supranationals. Importantly, many of the supranationals currently trade with very tight spreads to Treasuries and are very illiquid, which means transaction costs alone can offset any excess return potential for the sector. Plans might therefore want to consider using corporate rather than credit indices. This may reduce structural exposure to the government-related sector, which can be an incremental source of tracking error relative to a plan’s discount rate — given that the discount rate is derived from the yield of corporate issuers.

Read more on the role of intermediate credit in a liability-hedging portfolio here.

6. Where are plans looking for alternatives to public credit?

Amy Trainor: Some plans are now using long-duration securitized assets in their liability-hedging allocation in an effort to mitigate concentration risk in the corporate bond universe, as well as to build in some potential downside protection for a spread-widening environment. Taxable municipal bonds are another sector that may offer diversification and potentially mitigate downside credit risk. Plans looking to make their liability-hedging allocation work a bit harder in pursuit of their surplus-return objectives are also considering strategies such as return-seeking fixed income, private credit (middle-market direct lending focused), private investment-grade placements, and portable alpha. We discuss these and other ideas in our recent paper, The evolution of derisking: Assessing new and time-tested liability-hedging ideas.

7. In the current market environment, are there opportunities to improve a return-seeking portfolio?

Jake Brown: We think there are several reasons to consider a more diversified return-seeking portfolio in the current environment. For example, diversifying the return-seeking allocation can potentially help preserve recent funded-ratio gains, either as a complement to — or substitute for — traditional derisking from equities to liability-hedging fixed income. 

We also think the potential for higher asset volatility amid more frequent cycles and the wide range of possible economic outcomes — including the risk that central banks tighten their economies into recession or that inflation falls but remains volatile and structurally above central bank targets — make this a prudent time to consider incorporating more defensiveness and diversification into a return-seeking strategy. (Our Fundamental Factor Team wrote about the case for defensive allocations here.)

Finally, one diversifier we think is particularly interesting in a structurally higher-inflation environment is listed infrastructure, as companies that own long-lived assets can often pass through higher costs, either explicitly or implicitly. The historically steady nature of returns on long-lived assets, which are often set and protected by regulation or contract, may also make this asset class appealing — given their potential for offering lower volatility and outperforming broad equities in downturns. Finally, strategies that focus on companies poised to benefit from the transition to less carbon-intensive energy sources may also benefit from growth tailwinds, in our view.

For more on the role of defensive and diversifying strategies, see our recent paper on return-seeking portfolio construction.  

8. Given the volatile economic and market conditions, is there a role for alternatives in return-seeking portfolios?

Jake Brown: Lower-beta hedge funds and private credit (as part of a return-seeking fixed income allocation) may offer downside mitigation to equities across a range of environments while still preserving the opportunity for funded-ratio improvement over time. 

For plans that need their return-seeking assets to work harder, either because they are underfunded or because of derisking, it could help to lean into active management via high active share or extension strategies. Private equity, particularly later-stage funds with shorter lockups, could play a role too. For plans at or near the end state but still considering return-seeking opportunities, our recent end-state paper provides a framework for assessing liquidity needs. Plans may find that even though they have near-term liquidity needs, they can continue to be a liquidity provider to meet cash flows that extend over 10 years or even more. 

Of course, we have also heard from some plan sponsors that the decline in public equities in 2022 left them overallocated to private equity (the “denominator effect”). Reducing future commitment sizes may be a simple way to navigate this (as opposed to reducing existing allocations), though cutting future commitments too far risks missing out on attractive vintage years that sometimes follow a market downturn. Some allocators we’ve spoken with have explored the option of selling private equity holdings on the secondary market, and a few have noted that pricing was a bit better than expected.  Thus far, however, we’ve observed more sponsors electing to maintain commitments rather than taking this route.

9. With the improvements in funded ratios, is the focus shifting to end-state planning?

Amy Trainor: We do think a growing number of plans have been contemplating their investment approach for the “end state” — the point at which a plan moves from being underfunded to being fully funded or even having a surplus. At that point, the goal typically shifts from improving the funded ratio to maintaining (or spending down) a plan’s surplus. We recently published our research on this topic, and our key takeaways included:

• Return-seeking assets are still likely to play a role in the investment strategy at the end state, and diversifying those assets can help balance different end-state goals. 
• The majority of assets will likely be in the liability-hedging allocation, and differences in this allocation can have a large impact on volatility, making thoughtful portfolio construction essential.
• And as Jake noted above, some plans in the end state may be surprised to find they have the ability to be a long-term liquidity provider, and that could open up a role for less-liquid asset classes or a cash-flow-driven investment (CDI) approach.

10. With the growing use of cash-balance plans, how are plan sponsors thinking about the integration of cash-balance and traditional liabilities?

Amy Trainor and Louis Liu: Many plans started out using a traditional benefit formula (e.g., final average pay) and later converted to a cash-balance design, leaving them with both traditional and cash-balance liabilities. In thinking about how best to integrate these very different liabilities in a plan’s investment strategy, we’ve arrived at a number of general conclusions:

• We believe a dedicated cash-balance approach should have a dual objective of 1) maintaining low risk, in alignment with the liability’s riskless, bank-account-like nature, and 2) keeping pace with the plan’s interest-crediting rate. In our estimation, many current cash-balance investment strategies aim to manage the cash-balance liability risk characteristics with a duration-blended approach (i.e., targeting the weighted blend of the longer-duration traditional liability with the near-zero-duration cash-balance liability), but are not focused on matching the interest-crediting rate accrual.
• Such a dedicated cash-balance approach may be better equipped than a simple duration blend to maintain a plan’s funded ratio (via its focus on the interest-crediting rate accrual) while still keeping funded-ratio volatility low and manageable. 
• This type of dedicated cash-balance approach may also be effective when considered in conjunction with return-seeking assets, potentially allowing for a higher funded-ratio return.
• It may be worth beginning to think about such a dedicated approach for cash-balance liabilities when they amount to 20% – 30% or more of total plan liabilities. While every plan’s goals and risk tolerances will vary, our research suggests that this may be the point at which the funded-ratio return give-up versus simply matching the duration of the cash-balance liability (but not focusing on the interest-crediting rate accrual) becomes more penalizing.

The continued shift toward cash-balance liabilities as legacy traditional liabilities wear away (or are annuitized), as well as the impact of higher interest rates (causing many “greater of” cash-balance interest-rate formulas to move off a fixed-rate minimum and resume being tied to a variable longer-term Treasury yield), may be catalysts for reviewing a plan’s cash-balance investment strategy in 2023. More detail is available in our recent article on this liability integration process, as well as in our paper on cash-balance plans.

¹Market data and funded-ratio estimates as of 30 December 2022. Funded-ratio estimates based on year-end 10-K filings of Russell 3000 companies. Year-end 2021 funded ratios based on 10-K filings of Russell 3000 companies with a December fiscal year end. Current funded ratios and discount rates estimated by Wellington Management based on the change in high-quality corporate bond yields (Bloomberg US Long Credit Aa) since 31 December 2021 and performance of equities (MSCI World), bonds (blend of Bloomberg US Long Govt/Credit and Bloomberg US Aggregate), other investments (blend of HFRI Fund Weighted Composite Index, MSCI ACWI, and Russell 2000), and real estate (NCREIF Property Index). PPA funded ratio based on estimating liability at a single equivalent discount rate, calculated by applying the pension stabilization corridor under the Infrastructure and Jobs Act (IIJA) to 25-year-average, high-quality corporate bond rates, based on IRS-published full yield curves from August 2007 – August 2022, and market-value-weighted blend of Bloomberg Long Credit A, Aa, and Aaa indices prior to 2007, to a representative liability. Actual results may differ significantly from estimates. Results presented at the aggregate Russell 3000 Index level. For illustrative purposes only. Data is that of a third party. While data is believed to be reliable, no assurance is being provided as to its accuracy or completeness. | Sources: FactSet, Wellington Management