Phoebe White, Jay Barry and the rates strategy team at JPMorgan published an interesting note over the weekend looking at the US defined-benefit pension landscape and its use of liability-driven investing.
The tl;dr is that despite some similarities (like in the Netherlands), US pension plans are less exposed to the kind of margin call doom loop that enveloped UK plans in recent weeks.
Just like their international peers, the roughly $3.2tn worth of private American DB funds have been tilting heavily towards fixed income in recent years as they try to de-risk by matching their assets to their liabilities. Here is an estimation of their average asset allocations and how they’ve evolved since 2005.
That US plans are well-funded — the average funding ratio of assets to liabilities currently stands at about 114 per cent, according to JPMorgan — is little consolation.
After all, the funding ratio is largely a product of the ebb and flow of long-term high-grade bond yields, which are used to calculate the cost of long-term liabilities. UK plans are even better funded than American ones (about 125 per cent at the moment), and this didn’t prevent UK plans from suffering a market-rattling liquidity crisis.
However, JPMorgan’s analysts “do not see an elevated risk of forced selling of assets among the US pension fund community”, despite these superficial similarities.
To a large extent this is because in the UK there was actually a shortage of high-duration, high-grade, long-maturity fixed income that LDI strategies need, which forced many into using interest rate swaps as a synthetic, leveraged alternative, JPM argues.
The movements in the UK were unique, with a lack of domestic fixed income, as well as increased hedging costs when looking abroad, and a fiscal surprise starkly disjointed with monetary goals. A common challenge that many of these pension markets face (and investors outside the US managing assets broadly) is that the supply of long-duration assets has become increasingly USD-centric in recent years.
The USD share of >10yr sovereign + corporate bonds issued over the past two decades averaged 35 per cent in the first 10 years but then has nearly doubled to 65 per cent on average over the past 5 years, and USD issuance is on track to make up about 80 per cent this year, a new high.
Even beyond the heavy use of cross-currency swaps, there was heavy use of derivative overlays, making the community more vulnerable to margin calls, and our insurance analysts estimate that the size of the British LDI market, at around >£1tn, is relatively large in relation to DB obligations of around £2tn, in comparison to US markets.
Much of these derivative positions are in pooled-levered investment vehicles. While the collective nature allows for greater levered gains, there is a lack of incentive for quality collateral posting (of a typical tragedy of the commons type) and, in combination with long duration positions, increases the sensitivity of these funds to interest rate shocks and margin calls, thus raising risks of fire sales. The investment advisor NISA estimates that less than 10% of interest rate hedges in US funds come from derivatives and they are instead usually structured as separately managed accounts (SMAs) whose multiple levels of collateral backstops and centralized structure means they have more flexible margin requirements and less systemic risks.
Overall, this leads us to believe US funds should be less exposed to funding and liquidity risks than their UK peers.
Of these points, the last one is the most intriguing to us. This is the first time we’ve heard the argument that pooled LDI strategies undercollateralise — not just in quantity but in quality. We’ll probably find out how resilient the US pension landscape is soon enough.