Episode 56

 Tim Boomer on LDI investing in a rising rate environment

Tim Boomer, Senior Managing Director, Head of Client Solutions at SLC Management, discusses how rising interest rates have been impacting plan sponsors and other investment considerations they should keep in mind.

Steve Peacher: Hi everybody Steve Peacher at SLC Management again thanks for dialing into this episode. Today, once again I believe, I’ve got as guest Tim Boomer who's a senior managing director and head of client solutions at SLC Management, Tim thanks for taking a few minutes.

Tim Boomer (he/him): Thanks for having me, Steve.

Steve Peacher: So today we want to talk about LDI or ‘liability driven investing,’ which relates to pension plans, and this is a topic we've talked with Tom Murphy about on a recent “Three in Five” podcast and Tim talked about recent improvements in funding status for DB plans, I think largely related to the rising interest rates, but then there's been a lot of other volatility in the market. You're in the middle, with your team, in the middle of conversations with plan sponsors, what are you hearing about as it relates to funded status of corporate DB plans?

Tim Boomer (he/him): Yeah, thanks Steve. I think you hit it on the head there, and you know the improvements in funded status have really been pretty staggering across the board. So thinking about the U.S., you know corporate defined benefit plans specifically, depending how you measure it, the average funded status is probably close to 105% now, which is up almost 7% since the start of the year and about 15% since the end of 2020.[1] And that's the same theme in other areas too, so in Canada, the median solvency ratio is probably up 10%[2] over that same period. And like you said, for almost everyone the main drivers really been that sell off in rates, as well as widening of credit spreads. And both of those contribute to higher discount rates which drive down liabilities and funded status. In terms of how people are responding, there’s few different camps so on one hand there's a lot of folks who have already put in place plans to de-risk as funded status improves. And we've really seen those flows happening from you know growth assets to hedging assets, as people hit glide path triggers. On the other hand, I think there's still a couple of plan sponsors who are sitting on the sidelines and wondering if rates maybe have a little bit more room to run before they take the foot off the gas. So, I say I’m always very wary of telling people how much risk they should be taking, we do a lot of work with plan sponsors to understand the risk, to help quantify them, but at the end of the day, people do know own businesses better than we do, and they know the risks that they can bear in the plan. But it does feel like one of those moments to me when there's a real opportunity to lock in some of those funded status gains. And we've seen historical periods like this, where the run up in funded status, you know it doesn't last too long, it can be a bit fleeting, and so I think a lot of plan sponsor, maybe have more to lose at this point than they do to gain by leaving their chips on the table. And the final thing I’d say is that, on the subject of raising rates, we just have to remind ourselves that yield curves are already pricing in the market expectations for rate moves, so if we're sitting on the sidelines it really means that we're not just thinking rates might rise, but really that you think rates are going to rise further or faster than the general consensus. And my experience is there aren't many people who are really great at timing that kind of decision.

Steve Peacher: You know it may be counterintuitive for some of our listeners who aren't really tied into LDI strategies and pension fund funding status to think that funding status is improving, when they see equity markets going down and volatility in the markets, but it just speaks to how sensitive funding status is to interest rate levels and that a rise in interest rates is actually as positive for funding status as is a rise credit spreads. So, given that you've seen this big improvement of funding status, it's amazing it's on average over 100% now I think it's what you just said, and as plans think about de-risking, what are some of the things they need to think about or to do specifically?

Tim Boomer (he/him): I think that the point you bring up around a rate raising being a positive for pension plans is something that we have to remind ourselves, you know, every time we look at overall fixed income performance, you know we still want to be beating our benchmarks, but when those benchmarks are down it's generally good news for pension plan sponsors because they're seeing a big move on their liabilities. In terms of specifics, first I’d say to whether it's with SLC or different LDI-focused manager, any de-risking is probably a sensible move for a lot of DB plans at the moment in the current environment. Pension plans tend to have a bit of an asymmetric risk profile so as funded status goes up you know they have less to gain then they do to lose. And despite some of the nuances they can get into, the main things people can still do to lock in some of those funded status gains is to dial down some equity exposure, get their hedge ratio up to reflect their current funded status, focus on hedging some of the spread exposure inherent in the liabilities. Where it gets a little more nuanced is that as plan sponsors and moving down the glidepath there’s generally a couple of things happening, one is that they're typically getting more concentrated in certain asset classes, so in the U.S. that may be investment grade corporates or treasuries. With Canada, it might be more mix of corporate and provincials. The second is that they're giving up some of the upside from the equity allocation. So there's a few things we can do. One is I’d say to always take a look is how as we allocate more to the fixed income portfolio, if we have multiple managers, what's the overlap in terms of holdings and style, how's the tracking error relative to the liabilities and really question are we getting a diversified credit exposure in that portfolio. The second thing I’d take a look at it, maybe what's likely to drive future funded status volatility and that might be different to what drove volatility in the past as we got here. So typically as plans move down their glide path they tend to hedge some of the broader equity and duration risks, and that means that some of the more nuanced risks like credit exposure and curve risks can actually become bigger drivers of funding status volatility. And that often makes custom solutions you know a more attractive option for late-stage plans. And then finally it's a really questioning if there's other ways to expand the de-risking toolkit that we're using. So today, specifically, we see a lot of value in some of the asset classes like investment grade private credit or real estate or infrastructure, that don't fit neatly in those traditional black and white definitions of growth and hedging buckets. These are some of the assets that insurance companies have used to back to long term liabilities and they offer some extra upside, diversification to traditional assets. And they can also generate long-term stable cash flows that can be meet benefit payments.

Steve Peacher: Well I think your comments just highlight how complicated this is when you try to think of all these different factors to build the optimal portfolio in a given environment for funded, as its funding status has changed. As you refer to, and I refer to you know a few minutes earlier, there's a lot going on in this environment other than just rising rates. And this may be a technical question, so I ask it with some trepidation, given that you're an actuary so you might jump too much into the details, but outside of the obvious improvements to a plan from rising rates, what are some of the other implications for plan sponsors in the current environment?

Tim Boomer (he/him): So, I do try and keep the actuarial talk to a minimum, Steve and I know my mom likes to listen to these podcasts and she'll probably switch off at this point. So I’m going, I’ll try and keep it high level. I would push back on one thing there, we could make it sound very complicated, the truth is generally the principles of liability driven investing are fairly straightforward. And there are a lot of kind of very simple things people can do. I think it gets a bit more nuanced as you really get towards those later stages and that's what we were talking about with some of these points. In terms of some of the other impacts on pension plans in the current environment, you know when I think about open plans, those ones which still have benefits accruing or one’s with indexed benefits, you know where the actual benefit level increases with some link to inflation or another assumption. Those are a lot more common in the UK and Canada. I think in those we really have to be aware of the impacts of inflation on some of those assumptions that we’re actually using and what that could do to funded status. I think it’s really going to be interesting to see how actuaries are reflecting that inflation outlook as I’m not sure there's really a general consensus today on how persistent inflation will be or how effective Central Bank policy is going to be curbing it over the long term, and then maybe in the U.S. specifically when we think about cash balance plans, which lots of people will attest that I’d love to talk about, they have some really interesting dynamics going on at the moment in the current market. Typically for those who are less familiar with cash balance plans they're often the open part of a traditional defined benefit plan and they have a slightly different benefits structure, but they often get rolled in and invested alongside traditional final salary plans which can work out great. And in other cases it could be really wide of the mark. With cash balance plans was really important to look at is the interaction of two assumptions, so it's the rate at which we're projecting the benefits for it and that's the interest crediting rate, and the rate at which we're discounting it today and that's the discount rate that we use. And the interaction of those assumptions can really dictate the drivers of risk in the plan. And what we've seen recently is there's a lot of cash balance plans, where they have a flaw in one of those assumptions of a minimum crediting rate. And for the first time in a long time we really think interest rates get up close to that floor or even past it, and what that does, is it really causes the duration, or the risk exposures of that plan to swing around pretty wildly. Which as an actuary personally I find pretty exciting and I’m sure everybody would, but it makes really interesting hedging solutions, so if anyone has a cash balance plan and they want to talk about it my doors always open, Steve.

Steve Peacher: Was funny you mentioned your mother, my mother actually emailed me a few months ago and said, ‘Hey I listened to your “Three in Five” podcasts,’ and I thought, how did you get in touch with that? Well there's a lot going on in your comments and there's a lot that we could drill down on and for us we just don’t have the time, but I wanted to ask you one final question. In our last podcast I think we talked about your you know your hobby of surfing, and I think we were talking about maybe we're talking about sharks or whatever, but I heard you had another recent mishap surfing, so give us the 20 seconds on that.

Tim Boomer (he/him): Yeah, I think last time you asked me about sharks, this time a I had a lot less glamorous interaction. I went to catch a few waves and instead I caught a surfboard to the nose. More embarrassingly it was my own surfboard. And I did break my nose and at the same time discovered the I had more blood to lose, and I thought. The interesting thing was, as I lay there in a pool of blood on my board very few people seem to come over to help me, which I think reflects your prior question around fear of sharks, Steve. And also on the subject of mothers, it was the one day my mothers ever been to watch me surf and I walked out of the water covered in blood head to toe. So you know, like all grown men, I was happy to have my mom there, she's probably less happy to see the state I was in as I walked out.

Steve Peacher: Well you'll have to craft a more of a ‘he-man’ story around the, certain has to involve a bar fight of some sorts. Well, Tim thanks for taking the time and thanks to everybody, especially our mothers if they happen to be listening, for listening to this episode of “Three in Five.”

Tim Boomer (he/him): Thanks a lot, Steve.

 

[1] Funded Status for the current month is estimated and subject to change as final numbers are released. Data from reference Bloomberg Indices.

[2] The Annuity Proxy (Actual) references the appropriate spread to be added to the Government of Canada marketable bonds, average yield series, over 10 years ( CANSIM V39062) as a proxy for the annuity purchase yield for a medium duration pension plan, as published in Canadian Institute of Actuaries (“CIA”)’s educational notes on “Assumptions for Hypothetical Wind Up and Solvency Valuations” at various effective dates (“CIA’s educational notes”). Corporate and provincial spreads are the duration neutral.

 

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