November 13, 2020

Formulating an OCIO game plan to protect pension funding during unprecedented investment headwinds

 

This is the second in an article series dedicated to sharing Mercer’s latest thinking about how asset owners including US defined benefit (DB) plan sponsors can better shield assets from the COVID-19 pandemic’s potential value destruction. The first post focused on how Mercer’s outsourced CIO (OCIO) platform and trading teams were able to protect one plan’s funded status during Q1 2020 market meltdown. This post examines how market disruptions are creating opportunities for OCIO providers to fortify funded status for pension plans. 

Putting strategy to the test

 

No market observer could possibly have predicted the sharply negative impact that the COVID-19 crisis had on financial markets during the first quarter of 2020. The stock market as measured by the S&P 500® Index was down 35% in just 23 trading days — a drop in magnitude not experienced since the Great Depression. Adding to the massive disruption to the financial system were stay-at-home orders that complicated committee and financial institution’s ability to respond to rapid spikes in daily market volatility.

 

Mercer has over a decade of experience as an OCIO provider to pension plans and understands the challenges of managing pension assets through periods of market uncertainty and volatility. While the first quarter of 2020 was a trying time for pension plan sponsors, we relied on our established approach and platform to seize emerging opportunities and manage risk on behalf of our clients.

 

While the estimated aggregate funding level of US defined benefit (DB) plans sponsored by S&P 1500 companies decreased by 5% during the first three quarters of 2020, reflecting record-low interest rates and volatile equity markets, the average funded status of Mercer’s daily monitored DB OCIO clients in the US experienced a drop of 2% - 3% smaller than the S&P 1500 peer group.  The majority of this performance gain happened in the first quarter when equity sharply declined.

 

This builds on a long track record of funded status outperformance: Since 2008, the funded status performance for Mercer’s daily monitored DB OCIO clients has exceeded the S&P 1500 benchmark by over 19%.1

 

What drove this funded status outperformance? Above all else, we believe Mercer’s dynamic asset allocation approach was a key factor. Although the most successful approach to limiting downside risk will vary by the plan’s situation and objectives, there are a few general approaches that we consider as a named fiduciary when seeking to limit potential for losses. They include the following:

 

  • Review the diversification of assets, looking for concentrations of assets that tend to perform poorly in challenging environments and have limited upside
  • Appreciate the value that long duration Treasury bonds and STRIPS can provide in a market downturn, not only for hedging liability risk but providing a tail-risk hedge for risk assets in the portfolio a well
  • Increase flexibility seek to capture shifting market opportunities, such as absolute return, multi-asset strategies and distressed funds while considering tactical or dynamic asset allocation approaches and revisiting rebalancing guidelines
  • Assess the need to avoid specific short-term outcomes by considering downside hedging protection in the form of options or other strategies

Of course, any investment strategy designed to limit downside risk needs to consider the corollary of upside improvement when markets return to health. The Q1 2020 equity market downturn largely reversed over the summer. Plan sponsors should make it a goal to capture market opportunities before they may be fleeting and, within that framework, dynamically manage the underlying assets.

Three drivers support funded status improvements 

 

Protecting and improving a pension plan’s funding remains a shared responsibility for plan sponsors and OCIO providers, especially during the unparalleled period of market disruption we’ve experienced so far in 2020. In such markets, we believe three drivers generally have the greatest positive influence over funded status improvements:

 

  • Effective strategy: Flexible strategies balance program risk with cost outcomes to meet the sponsor’s unique objectives.
  • Dynamic asset management: As an experienced OCIO provider, our ability to leverage global research and an established investment platform allowed us to take advantage of opportunities across the spectrum.
  • Timely execution: With daily monitoring under a fully delegated OCIO approach, our team was able to execute on emerging opportunities quickly. 

Plan sponsors likely will need to brace for continued headwinds in 2021, as volatile markets, low interest rates and increased demands on pension funding continue to reshape the pension landscape. Particularly as organizations get back to some sense of normal amid the COVID-19 pandemic, we believe sponsors should focus on their most significant opportunities and risks when formulating a game plan.

Scott Jarboe, FSA
Scott Jarboe, FSA

Partner, US Defined Benefit (DB) Leader at Mercer

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1 Past performance is no guarantee of future results. Please see Important Notices or further information regarding Mercer’s DB OCIO client funded status results.

 

Mercer Funded Status Performance This analysis includes plans for whom Mercer built and managed a customized Liability Driven Investments (LDI) program and is based on calendar-year results. The analysis covered 5 plans for 2008, 9 plans for 2009, 9 plans for 2010, 16 plans for 2011, 23 plans for 2012, 27 plans for 2013, 37 plans for 2014, 47 plans for 2015, 59 plans for 2016, 64 plans for 2017, 65 plans for 2018 and 62 plans for 2019. The composition of the group changed each year to reflect the number of plans that were invested with Mercer in custom LDI solutions at the beginning and end of the year. Only plans with December 31 fiscal year ends were included to ensure consistency in reporting. Funded status is based on fiscal year-end accounting disclosure information consistent with 10-K reports, as provided by the client’s actuary. The funded status ratio for each plan represents the ratio of assets to liabilities. The Mercer average funded status ratio has been calculated as the average funded status ratio across all applicable clients for each year.

 

S&P 1500 Funded Status Performance Mercer estimates the aggregate combined funded status position of plans operated by S&P 1500 companies on a monthly basis. For S&P 1500 companies that do not have a December 31 fiscal year end, this is based on projections of their reported financial statements adjusted from each company’s financial year end to December 31 in line with financial indices. This includes US domestic qualified and non-qualified plans and all non-domestic plans. Source of Financial Statement Data: 10-K reports filed by the companies in the S&P 1500, as provided by S&P Capital IQ, a Standard & Poor’s business. The Mercer Pension Discount Yield Curve is used to estimate the change in discount rates for adjusting aggregate liabilities. Please see the following link for further information: https://www.mercer.us/our-thinking/wealth/mercer-pension-discount-yield-curve-and-index-rates-in-us.html.

 

Funded status performance is presented for illustration purposes only. There is no assurance that LDI investment objectives will be achieved. All investments experience gain or loss. Funded status performance data shown in this presentation represents past performance, which is no guarantee of future results. Additionally, funded status performance is unable to take into account plan contributions that may materially impact funded status as well as possible accounting techniques or methods that may evolve over time in calculating funded status. Specific investments and asset allocations vary across the Mercer LDI clients and S&P 1500 plans, due to factors such as timing of investment decisions, investment objectives, risk tolerance, funded status levels and perception of investment opportunities. Actual funded status performance of S&P 1500 plans may significantly differ from the estimated data shown herein. The estimated S&P 1500 funded status is used to illustrate broad market conditions for the relevant time periods and, depending upon the portfolio strategy, allocation, and a variety of other factors, should only be used as a broad-based indicator of general LDI performance. Asset allocations of the LDI clients for the time periods indicated may have varied greatly from the average S&P 1500 asset allocations represented over the same time period. Mercer’s LDI funded status performance for each individual LDI client available upon request.