Price Perspective - In Depth
Vol. 3 - Targeting Outperformance of ASC Liabilities
- Recent improvements in the funded status of many corporate defined benefit plans have accelerated interest in liability-driven investing (LDI) and led many sponsors to more clearly articulate their LDI objectives. However, the fixed income benchmarks typically used to measure the performance of LDI strategies can be improved.
- T. Rowe Price has developed a methodology for constructing custom LDI benchmarks at the most granular level—from the individual cash flows, both principal and coupon, derived from a given fixed income opportunity set.
- We provide a hypothetical example of a sponsor seeking to outperform liabilities as valued using accounting standards codification discount rates. A custom benchmark enables sponsors, consultants, and managers to focus on performance relative to the plan liability, which in our view is ultimately how LDI mandates should be measured.
THE NEXT STEP IN LDI EVOLUTION
As corporate defined benefit plans increasingly have shifted their focus to portfolio de-risking, many have sought fixed income benchmarks that are better aligned with the specific objectives they hope to achieve through liability-driven investing (LDI).
Some sponsors have shifted to longer-duration measures, such as the Barclays Long Credit Index or Barclays Long Government/Credit Index, while others have adopted compound benchmarks or duration-targeted indexes.
T. Rowe Price believes an even higher level of customization is both necessary and feasible. Accordingly, we have developed a methodology for constructing custom fixed income benchmarks at the most granular level possible—the individual cash flows, both principal and coupon, derived from a given fixed income opportunity set.
Based on the bonds in the relevant opportunity set, we create a benchmark that matches, as precisely as possible, a plan’s projected liability cash flows. To ensure continuous liability matching, this investible benchmark is then reset each year to reflect the plan’s actuarial experience, new pension cash flow accruals, and bond market developments.1
SPONSOR OBJECTIVE: OUTPERFORMING ASC ACCOUNTING LIABILITIES
Many corporate defined benefit plan sponsors are focused on improving balance sheet funded status, as defined by accounting standards codification (ASC), via fixed income allocations that create greater exposure to credit risk than the bonds used for liability calculations. In such cases, we believe that linking the outperformance target to liability returns is essential to achieving the desired objective.
To highlight the potential benefits of T. Rowe Price’s LDI customization process for these sponsors, we have created a benchmark for the hypothetical plan liability structure shown in Figure 1 (below). We assume the sponsor’s LDI objective is to outperform pension liability returns—based on U.S. ASC discount rates—by 100 basis points (bps) per year. In our view, such a benchmark might be appropriate for sponsors seeking to:
- outperform the liability in order to reduce funding deficits,
- maintain an open and ongoing plan,
- better align and attribute LDI investment manager performance,
- incorporate an active credit strategy designed to achieve the outperformance target.
We believe the custom benchmark would provide a much more precise match of the liability structure than would be possible using a standard market-weighted index, such as the Barclays Long Credit Index (Figure 1A). However, given the sponsor’s objectives, the opportunity set for the custom benchmark (Figure 1B) can be broadened to include bonds of lower quality than would be used for liability calculations.
Custom LDI Benchmarks Can Provide More Precise Matching of Plan Liability Cash Flows Hypothetical Plan Cash Flows Valued Using ASC Discount Rates
Data as of 30 Sept 2015
Sources: T. Rowe Price; data analysis by T. Rowe Price.
In our example, the investment universe incorporates the entire investment grade (IG) spectrum (AAA to BBB-), essentially matching the quality constraints for the Barclays Long Credit Index. This opportunity set reflects the fact that many LDI mandates currently use the Barclays Long Credit Index as a benchmark, which implies that some sponsors are willing to accept at least an equivalent degree of credit risk in other LDI portfolios. The 10 largest issues in our hypothetical custom benchmark are shown in Figure 2 (below).
A benchmark constructed in this manner will have similar duration, convexity, and cash flow characteristics as the liability, which should facilitate the attribution of LDI portfolio performance. The portfolio manager’s objective, then, would be to construct a portfolio with similar characteristics as the custom benchmark, while employing his or her skills in security selection to seek to generate a 100 bps yield advantage over the liability discount rate.
Ten Largest Issues in a Hypothetical Custom ASC Liability Benchmark2
As of 30 Sept 2015
|Port Authority NY & NJ 4.93 '51||2.06%|
|Verizon 4.9 '46||1.77|
|UC Medical Center 6.55 '48||1.61|
|Verizon 4.52 '48||1.59|
|Peru 5.63 '50||1.43|
|Uruguay 5.1 '50||1.25|
|Illinois 5.10 '33||1.24|
|Panama 4.30 '53||1.03|
|Ascension Health 4.85 '53||0.93|
|Port Authority NY & NJ 4.46 '61||0.69|
Source: T. Rowe Price.
Figure 3 (below) shows some of the key characteristics of a hypothetical portfolio constructed using this approach. Such an LDI mandate could be used to complement and diversify from other LDI managers that have similar outperformance targets, but relative to published market-weighted benchmarks rather than an investible representation of the plan’s liability.
Key Characteristics of Hypothetical Plan Cash Flows, Barclays Benchmarks, and a Hypothetical Custom ASC Liability Benchmark2
As of 30 Sept 2015
|Plan Cash Flows (ASC)||12.5||2.7||4.38%||AA|
|Plan Cash Flows (IRS)||12.5||2.8||4.39||AA|
|Barclays Long Credit Index||13.3||2.6||4.88||A|
Source: Barclays, T. Rowe Price; data analysis by T. Rowe Price.
Past performance is no guarantee of future results. Custom benchmark and Sample Plan returns do not reflect the deduction of management fees.
T. Rowe Price believes LDI performance benchmarks should reflect each plan sponsor’s specific investment goals and objectives. To that end, we have developed a customization methodology that we believe will enable sponsors to align their fixed income allocations and their LDI objectives with far greater precision than either standard market benchmarks or more specialized duration-targeted or compound indexes.
Customized benchmarks also should allow sponsors to provide investment managers with more precise mandates and allow more granular performance attribution for both plan assets and plan liabilities.
1For a fuller description of T. Rowe Price’s methodology, please see the Appendix.
2Please refer to the disclosures at the end of this material for important additional information.
This material is directed at institutional investors only and has been prepared by T. Rowe Price Associates, Inc. for informational purposes. This information is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of July 2014 and are subject to change without notice.The information presented has been developed internally and/or obtained from sources believed to be reliable; however, T. Rowe Price does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained herein may no longer be true after the date indicated. Any forwardlooking statements speak only as of the date indicated and T. Rowe Price assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forwardlooking statements.Each of the hypothetical plan(s) and custom benchmark(s)/sample strategy presented reflects a model and is not indicative of an actual plan or benchmark or attendant characteristics. The hypothetical plan is representative of an annuity based defined benefit pension plan. The hypothetical custom benchmark(s)/sample strategy is based on the applicable bond universe for the relevant liability measure. Certain of the assumptions have been made for modelling purposes and are unlikely to be realized. The hypothetical plan, and thus the custom benchmark as well, have been created for modelling purposes with the benefit of hindsight. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in creating the hypothetical plan and custom benchmark have been stated or fully considered.Changes in the assumptions may have a material impact on the hypothetical returns presented. The construction of the plan and benchmark in this manner has certain inherent limitations and may not reflect the impact that material economic and market factors may have had on the custom benchmark construction if an actual plan had existed during the time period presented. Actual tracking of T. Rowe Price’s custom benchmark of any particular plan, including (among other things) yield, annualized return, liability-relative tracking error and average monthly return may differ substantially from the hypothetical scenario presented herein. The specific issues referenced herein should not be viewed as recommendations and it should not be assumed that any investment in the securities identified was, will or would be profitable.The information presented is supplemental information for GIPS purposes; however, because T. Rowe Price does not currently manage any accounts the strategy presented, a GIPS-compliant presentation is not available. A complete list and description of the firm’s composites is available upon request.This document, including any statements, information, data, and content contained therein, and any materials, information, images, links, sounds, graphics, or video provided in conjunction with this document (collectively, “Materials”) are being furnished by T. Rowe Price for your general informational purposes only.