2021 off to an epic start for DB risk takers
It’s not surprising that a blogging actuary from Pittsburgh doesn’t know much about surfing. Waves are pretty scarce around these parts, and actuaries are by nature a fairly risk averse lot. (Frankly, the sport has terrified me ever since Greg wiped out on his Brady Bunch Hawaiian vacation.)
But being a shubie doesn’t mean I can’t appreciate the incredible results of the daring few who successfully hang 10. Sure, many attempts result in spectacular wipeouts. But when executed properly, courage and risk taking can produce immediate, incredible results.
For some risk taking defined benefit (DB) plan sponsors, the first quarter of 2021 was a gnarly rush!
Riding the rate wave
This blog for years has explained the powerful effect corporate bond rates have on pension liabilities. Unfortunately, this effect has been negative for most of the past three decades as rates trended steadily downward, exerting significant upward pressure on pension obligations. After a COVID-related blip and plunge, bond rates dragged bottom for the last six months of 2020 near all-time lows.
2021 brought abrupt change. Bond rates popped 20 basis points in the first week of the year and have continued to steadily climb. By the end of March, high quality corporate bond yields were up almost 70 basis points, reducing liabilities of a typical DB plan by seven to 10%.
Meanwhile, return seeking pension portfolios were holding their own. Equity returns were positive, and core bonds responded better to rising interest rates than liabilities. A typical “traditional” allocation of 60% equities and 40% core bonds returned about 2% for the quarter (nine to 12% net vs. liabilities). A plan invested this way with a 70% funding ratio on January 1, 2021 has totally shredded it, riding the rail closer to 80% after only three months.
For a brief moment at least, those intentionally mismatching liabilities with their allocations are having a moment in the sun, while more conservative liability driven investors (LDI) paddling on the side look on in grudging admiration. (Dude!)
Shooting the tube
The question for sponsors now is how long to continue shooting the tube. Many economic forecasters are calling for a few more quarters of tasty waves, so it may be tempting to continue the ride. But glide path theory suggests that DB investors tend to become more risk averse as funding ratios improve.
Another strong quarter would be righteous, but the longer the ride goes the more tempting it becomes to bail out and join the LDI paddlers. With so many economic variables swirling around, knowing when to lock in gains becomes ever more important. Glide paths within investment policy statements can help remove the guesswork from this decision-making process.
Risk taking is awesome when it works, but take heed, bro! Funding ratios today are now at their highest levels in over two years. There are no guarantees that rate increases will continue, and even if they do there is no promise that equity markets will respond favorably to the trend. (When exactly does economic optimism become inflationary pressure?)
Feel free to use the Principal Pension Risk Management Dashboard to track DB-relevant economic statistics as you time your dismount. Because unknowingly losing recent gains to another sudden flight to quality would be totally bogus!
Mike Clark is a fellow of the Society of Actuaries (SOA), a member of the American Academy of Actuaries (AAA), who sadly has never come closer to actually shooting a tube other than watching the opening credits to Hawaii Five-O.
Source for chart/image: Principal Pension Risk Management Dashboard
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment, or tax advice. You should consult with appropriate counsel, financial professionals, and other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
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