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Q&A: Making long-term bonds speak actuarial

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02/16/2015 | Gary Knapp

While every company has financial obligations, pension plans and insurers are unique in facing obligations that literally last a lifetime. When you consider that medical advances and healthier lifestyles help people live longer, those obligations will only grow. While insurers long ago turned to actuaries to help meet their obligations, some pension plans are in danger of being overwhelmed by theirs. Gary Knapp of Prudential Fixed Income discusses these challenges for plan sponsors, and strategies that may help.

 

Given all you’ve seen in your time at Prudential, can you describe the evolution of the company’s liability-driven investment (LDI) approach to asset management?

Inside the insurance company, we were already using actuarial models to integrate investment strategy with our insurance liabilities in our efforts to offset risks whenever possible. So when pension clients asked whether their investment strategies could support the lifetime promises made to their employees, it was natural for us to apply the same techniques to corporate pension portfolios.

 

Is there an advantage to our actuarial viewpoint relative to traditional asset managers?

Traditional LDI managers usually focus on beating an asset benchmark over a market cycle. They don’t necessarily focus on long-term actuarial risks or credit migration over multiple cycles. One of the things that distinguishes Prudential is our heritage as an insurance company, more than a century of making good on lifetime guarantees. So our thinking is more aligned to pension plans. Plans are now realizing they’ve made insurance-like promises to participants and many of our techniques translate. Applying that same actuarial viewpoint and then linking that to the interest rate, credit risk and growth potential inherent in those liabilities is crucial to an integrated view of risk.

 

What needs to happen to match assets to liabilities for investment outcomes that last 75 or 100 years?

I often say a portfolio isn’t a hedge. It’s a hope. The market doesn’t provide bonds with maturities that last as long as an employee may live. So you can’t make all the risk go away with bonds. All you can do is try to reduce it as much as possible and be smart about residual risk. So you need to understand where assets and liabilities work together — and where they don’t. For example, CIOs know the duration of their liabilities but they may not know how much spread risk is implied by their actuarial discount rate, even though that risk can be quite large.

 

So if bonds only cover potentially 30 years of liabilities, what about employees who may have another 50 years to go?

Breaking liabilities into pieces makes them easier to understand. Current retirees are owed payments each month. Sponsors shouldn’t take a lot of investment risk with those obligations. So you need low-risk strategies like high-quality fixed income. Then you have to consider current employees. These people are younger and we all hope their lives will continue well beyond the 30-year maturity of the bond market. Now that’s an interesting discussion with a CIO. They know fixed income is a good strategy for retirees, but now they also need growth assets because of the long horizon of the promises to those younger participants.

 

I want to get back to managing those residual liabilities. Can you explain how that works?

Once you’ve achieved the best asset liability match in the bond market, you have to start working with other assets. These should all be viewed as global asset classes — stocks, real estate, private equity, other alternatives. Here the tools change from interest rate sensitivity and actuarial analysis to traditional asset allocation techniques — using risk efficiently by getting a lot of return for each unit of risk.

 

Does Prudential’s long-term perspective influence our approach when it comes to matching liabilities and assets?

When we take a position at Prudential Fixed Income we think about the remaining lifespan of our customers. That’s a very long investment horizon. We focus on managing the risk of a position not just through the next recession, but the three or four after that. Since 2006, more and more plan sponsors have adopted that same perspective. Corporate plan sponsors have begun to think, “Hmm, I’m obligated to these employees a really long time. I can’t think only about its effect on this quarter’s earnings or our five-year plan because that’s really too short to properly manage all the risks of our pension plan.”

 

 

What are the benefits of applying our integrated approach to actuarial risk management, credit research, and portfolio management?

Our clients have actuarial advisors, accountants, investment consultants, several other asset managers and so on. Prudential Fixed Income has all the same capabilities. So every client wants to know what we bring to the table and how we can effectively plug into the jigsaw puzzle of support that already exists. Because we have these many capabilities, we’re very good partners. We understand the role each advisor plays.

 

Can you give an example?

Sure. We had one client who wanted to take most of a day to discuss their plan’s long-term strategy. The CFO invited their actuarial and investment consultants, the company’s senior financial executives, as well as Prudential Fixed Income as LDI manager and a team from Prudential Retirement. We have all these capabilities, so we engaged with all of their advisors. We understood the actuarial issues and could engage with the actuaries and their recommendations. We’re also investment managers, so we worked with the investment consultant about the risks of managing credit migration against a liability that could last many decades.  

 

One final question. What effect might rising interest rates have on pension liabilities?

If long-term rates rise a bit, it’s likely to be slightly positive. Modestly higher rates lower the present value of those future liabilities so most plans will become a bit better funded. But, rising rates may not be good for equities, and pension plans have significant portfolios of growth asset exposure. Our view on long-term rates over the next year is that not much is going to happen. If anything, we believe they may be lower due to slower economic growth. But many pension plans have large exposures to equities, and plan sponsors need to think about whether a series of Fed rate hikes increases the risk of market volatility during the next year. It definitely increases the risk of a recession in the next few years.

 

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About the Author

F. Gary Knapp, CFA, is the Managing Director and Head of Insurance and Liability-Driven Strategies at Prudential Fixed Income.

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