With many defined benefit pension plan solvency ratios at all-time highs, plan sponsors have an excellent opportunity to rethink their approach to investing, according to Shivin Kwatra, head of liability-driven investing portfolio management at Insight Investments.
“It is important to highlight two approaches to investing: one [is] traditional — a mean variance framework of maximizing returns and minimizing risk,” he said during a session at the Canadian Investment Review‘s 2021 Investment Innovation Conference. “The other is about maximizing the certainty of outcome. When a plan is in the accumulation stage, the traditional framework of mean variance may suffice, as the end goal is far out in the future.
“However, if your plan is in the decumulation stage, when the outflows exceed inflows and the focus shifts to the end goal as it draws nearer, more precision is needed as you have less flexibility and time to recover from market setbacks with a shorter timeframe. In this case, an outcome-oriented investing approach — trying to maximize the certainty of your desired outcome — is much more important.”
When focusing on the end outcome, the objectives and risk-management focus needs to change, said Kwatra. For mature plans, plan fiduciaries should be conscious of three pillars of investing, each helping to address three major sources of risk. The first is that cash flows must be paid by plans when due, helping to minimize forced-selling and reinvestment risk. Second, plans must manage investment risks and reduce liability risks as much as feasible, reducing the volatility of plan solvency ratios. Third, growth above the discount rate of liabilities must be achieved, but in a protected way avoiding potential for large drawdowns.
“Cash flow, liability risk management and growth — these three pillars can be thought of as the broad objectives of defined benefit portfolios,” he said. “Managing liquidity and cash-flow matching can help you ensure the certainty of benefits getting paid.”
Also, for mature plans, which are already paying cash benefits, the timing of returns is of greater importance. To manage liquidity risks, Kwatra suggested plan sponsors adopt a cash-flow matching strategy.
“It’s quite simple. You take the cash flows from your bonds, the principal payments and the coupon payments and you align them with your liability cash flows. That can be incorporated as part of your broader management plan. So you could have other sources of cash contributions, like those from dividend payments and alternative investments that can be used for other purposes than benefit payments or expenses and other requirements of the plan. All of that can be coordinated so that your cash inflows and cash outflows can be more closely and precisely aligned.”
In the current environment, more pension plan sponsors are adopting a dynamic cash-flow matching program comprised of government and corporate bonds, as well as structured credit, private debt and emerging markets debt, he said.
“Dynamic and intelligent protection strategies can be used to try to reduce the cost of protecting your return-seeking portfolio. There’s no free lunch, but there are approaches that can help you make the trade-off between reliability and cost and then there may be parts of the distribution that you value differently from the market.”
Taken together, noted Kwatra, liquidity management, liability hedging and downside protection strategies can serve as a significant tool in any plan sponsor’s arsenal. “Managing liquidity and cash-flow matching can help you ensure the certainty of benefits getting paid. Reducing your risk by hedging your liabilities in an explicit way, with specific liability benchmarks, can help you get to a more certain outcome.”