This two-part article series is dedicated to sharing Mercer’s latest thinking about how US institutional investors can better shield assets from the pandemic’s potentially value-destroying aftershocks. This first post focuses on a case study of how Mercer’s outsourced CIO (OCIO) platform and trading teams were able to protect one plan’s funded status during the turbulent markets of Q1 2020. (Click here to read part two.)
Speed matters: Reducing risk in volatile markets
Financial-market turbulence related to COVID-19 economic realities were pronounced in the first quarter of 2020. Global equity markets peaked on February 19. But by March 23, the S&P 500® Index was down 35% in just 23 trading days. As liquidity suddenly evaporated, most investors were given little time to execute pre-emptive measures to protect asset values. Adding to the challenge globally were stay-at-home orders that affected the ability of committees and financial institutions to respond to the rapid spike in daily market volatility.
However, Mercer was fortunate to see that our robust OCIO (outsourced chief investment officer) operating platform and trading teams allowed our investment professionals to work effectively to monitor in-place plan strategies and execute rebalancing trades during this highly changeable environment.
One particular client case study is worth noting, as it illustrates how important it is to understand a client’s unique objectives while remaining nimble enough to execute when changing market conditions warrant.
In this case, the sponsor of a frozen US pension plan with ~$800 million in assets has an ultimate goal of plan termination. Since 2017, Mercer has worked with this client as a fully delegated OCIO to pursue our clients’ intermediate objectives of minimizing cash contributions while mitigating the downside risk of large required contributions. Download the case study.
An ounce of prevention is worth a pound of cure
Following Mercer’s strategic analysis of the plan in 2017 and subsequent strategy design, the client implemented a dynamic de-risking, dual-trigger glide path strategy (see simplified illustration below). The funded status of the plan drives the allocation to return seeking assets (e.g., equities), and the level of interest rates drives the interest rate hedge ratio target.
When the funded status hits pre-specified thresholds, the plan’s asset allocation is adjusted to reduce return-seeking assets and buy liability-hedging assets. Mercer also uses interest-rate triggers to reduce interest-rate risk as interest rates rise from historically low levels (and thus the opportunity for funded status improvement from rising rates diminishes). When interest rates rise above certain predetermined thresholds, the duration of the liability-hedging portfolio is extended to increase the interest-rate hedge ratio.
In late 2019, based on our internal dynamic asset allocation outlook, we recognized that corporate bond credit spreads had fallen to levels where the risk/return tradeoff was becoming less favorable to the plan, and adjusted the structure of the plan’s liability hedge portfolio (much as we had multiple times since implementing the dual-trigger risking strategy in 2017). We significantly reduced the credit allocation within the liability hedge portfolio in December 2019 and January 2020, selling $90 million of credit exposure in favor of US Treasury exposure.
While we did not predict the sudden impact of the COVID-19 crisis that soon followed, we were dynamically adjusting the portfolio for developing risks that subsequently provided substantial downside protection in 1Q 2020.1 Overall, the funded status triggers, interest-rate triggers and dynamic management of asset allocation in the liability hedge portfolio protected $9 million of the plan’s funded status in the first quarter of 2020.2 In addition to this dynamic asset management change, funded status de-risking triggers executed in 2019 along with interest rate triggers to extend duration in 2018 led to a total of $23 million of funded status protected in Q1 2020. These actions demonstrate effective strategy, dynamic asset management, and timely execution in our OCIO platform.
During this unparalleled market disruption, the risks related to institutional investment management have been greatly heightened, and the benefits of our approach have been simultaneously amplified. Mercer has demonstrated that in markets such as these, a strong track record of success helps us potentially capture attractive market opportunities — and lessen downside risk — for our clients.
Next article: Market disruptions are creating opportunities for OCIO providers to fortify funded status for pension plans. Click here to read part two.
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1This case study illustrates Mercer’s capabilities provided to certain clients. Client results will vary and there can be no guarantee of similar results.
2Mercer estimates that the actions described above resulted in preservation of $23 million in funded status compared to what the decline would have been during Q1 2020 had these actions not been taken. This estimate was derived by comparing the hypothetical returns for the plan assets assuming the asset allocation and hedge ratio prior to the funded status triggers, interest rate triggers and credit reduction had been in place during Q1 2020, and comparing that to the plan’s asset allocation and hedge ratio in Q1 2020 reflecting these actions.