Fidelity Preps Clients for Interest Rate Changes
One of the most significant deterrents that have kept pension plans from adopting liability-driven investing (LDI) – the expectation of rising interest rates – might in fact be misunderstood. Pyramis Global Advisors, the institutional arm of Fidelity Investments, is looking to educate investors on the intricacies of how interest rates impact LDI and says that interest in the strategy is picking up steam.
LDI lacks a standard definition, but basically means matching a plan’s assets to its liabilities, usually using long-term fixed income and derivatives. Managers have touted its imminent arrival for years, though it has yet to actually take off. One key point that Pyramis is making these days, in part through a newly released white paper, is that when the level and slope of the yield curve are taken into consideration, the performance between a core bond strategy and LDI might not show much differentiation.
Experts say that plan sponsors should consider using LDI as a way to protect against pension funding risks--something that has taken on even greater importance after 2008, or even after August when the average funding ratio for U.S. corporate plans dropped by 5.6%. Besides interest rates concerns, plans have also been hesitant to use an LDI strategy because of their underfunded status, which has improved since the late summer swoon.
Daniel Tremblay, an institutional portfolio manager for Pyramis, says that interest rates have “a rather dynamic impact on the plan,” depending on how rates rise or change. In August, for instance, rates declined on the long end of the yield curve, which along with falling equity markets helped push funding levels down. But even though the general consensus among plan sponsors appears to be that interest rates are going to rise, Pyramis cautions that this might only be true for the front end of the yield curve, where rates are near record lows.
Longer term rates, on the other hand, are not as low as intermediate rates from a historical perspective and still have room to fall. This would be especially true if deflation picks up, which would put “significant downward pressure” on the funding levels of pension plans, the firm says. In other words, trying to predict how the volatility of rates along the yield curve might impact funding status could be a losing cause.
“The curve is historically steep, so when [interest rates] rise, they will not rise evenly along the curve,” Tremblay says. “There is no clear answer on the impact it will have on a pension plan. You can’t paint this with one broad stroke.”
In the white paper, Tremblay, along with Michael Senoski, the firm’s LDI investment director, and Ben Tarlow, quantitative analyst, argue that the underperformance of an LDI strategy relative to a core bond strategy would be mitigated in the “fairly likely event” of the yield curve flattening. This assumes that interest rates “rise from the current levels toward more typical levels.” But if deflation does increase, this would lead to a “substantial” uptick in liabilities and a drop in plan funding levels – especially in the case of a core bond strategy.
Christopher Levell, a partner at consulting firm NEPC, advises clients not to wait for better rates before implementing LDI because it’s difficult to predict how they are going to move. Plan sponsors should instead go through the manager search process and then even fund a manager they like at a small level. This way they have the facility in place and then can activate or increase the hedge based on the conditions. He also advises sponsors not to go beyond a 70% to 80% hedge on their liabilities. This means getting past the “performance race,” in which the focus is weighted heavily to how assets are doing, and instead focusing on the volatility of the liabilities.
Sean McShea, president of Ryan Labs Asset Management, says it’s also important for a plan sponsor to look at its own risk capacity when implementing LDI. The stronger the balance sheet, the more freedom a sponsor has in attacking the liability.
“If your funding level is at 75%, then that’s going to require more contributions and not just aggressive asset allocations,” he says.
Although many would argue that LDI in the U.S. has seen a lot of talk but relatively little action, Tremblay says that there has been more movement over the past 12 to 18 months to “set some kind of action plan” by clients interested in LDI. In fact, Pyramis has funded $800 million in LDI over the last six weeks. Tremblay notes that at the past couple of conferences that he and Senoski have attended, the questions about implementation are getting much more detailed.
“It is moving from the academic to the real world and about how to get this done,” Tremblay says.