Corporate DB Plans: Selectively Manage Risk and Adopt a More Defensive Playbook
The severity of the COVID-19 outbreak will continue to test markets. The recent US market drawdown stands out not only in terms of its absolute magnitude but also in terms of the speed at which it happened with the pandemic and an upended global energy economy serving as catalysts. Based on historic average monthly returns during sell-offs, the current drop is a clear outlier as moves of this magnitude and velocity were witnessed only during the downturn of 1987 and the crash of 1929. The pace is much more rapid than during the global financial crisis (GFC), when markets took 18 months to collapse from peak to trough. As we enter Q2 2020, we find many aspects of the investing world in conditions that have rarely been experienced, which continue to make liability and long-term investment based management a challenging exercise.
The S&P 500 Index plunged 32% in March as the longest bull market in history transitioned to a speedy bear market in just 16 trading days. As a result, volatility surged, and investors continued to seek liquidity for benefit payment outlays, rebalancing purposes and corporate finance cash needs. Whereas markets have sharply rebounded since the lows experienced in the middle of March, there has been very little faith in this rally as investors still lack clarity around the nature of the crisis vis-à-vis the duration and depth (eventual market bottom) of the sell-off. Although one can see across to the other side of the river, how deep the river itself is unclear (with respect to job losses, credit and earnings downgrades and defaults). While liquidity has improved due to unprecedented central bank and government interventions, it is too soon to call an all-clear on financial market functioning. Thus, economic forecasters and asset allocators are faced with two separate questions. The first question is about understanding how long the economic shutdown will last and how severe the immediate economic drag is going to be. The second one is regarding the time that would take before economic activity returns to normal. The answers on both fronts are challenging given lack of precedence. In this context, calling the absolute bottom is a fool’s errand as markets expect near-term volatility to continue.
As the current crisis continues to unfold, progress is made in combatting the virus and forthcoming economic data unfolds compared to what has been priced in, institutional investors may increasingly look at strategic ways of rebalancing or shifting their asset allocation in a gradual, cautious manner. Investors who have an intermediate to longer-term horizon may consider recent events as a buying opportunity. However, plan sponsors and investment committees need a strategy that is calibrated for the near-term environment of continued low interest rates and volatile risk asset markets. The high-quality nature of the discounting methodology for corporate defined benefit (DB) plan liabilities has meant that liability values have risen as risk assets, especially equities, have fallen. Wider credit spreads over the period dampened the blow, but falling Treasury rates and greater drops in equities meant assets did not keep pace with liabilities. This has translated into an erosion in funded status year to date with plans that are more heavily tilted toward return seeking assets (equities in our illustration below) seeing greater degradation.