By: Andy Hunt, CFA, FIA and Jonathan Hobbs, CFA, FSA, Allspring Global Investments
The latest revision to Actuarial Standard of Practice (ASOP) No. 4 is upon us. Andy Hunt and Jonathan Hobbs, from Allspring Global Investments' Pension Solutions team, review the implications for how public pension plans need to think about and invest their fixed income portfolios.
This is an excerpt from NCPERS Summer 2023 issue of PERSist, originally published July 18, 2023.
The latest revision to Actuarial Standard of Practice (ASOP) No. 4 is upon us, and we believe it will have implications for how public pension plans think about and invest their fixed income portfolios.
Why it matters
ASOP 4, “Measuring Pension Obligations and Determining Pension Plan Costs or Contributions,” has just been updated. The headline is that all pension plans' actuarial reports are now required to disclose an additional liability value known as the Low-Default-Risk Obligation Measure, or LDROM.
State and local pension plans have used—and will continue to use—the so-called accrued actuarial liability value. This liability value discounts projected benefit payments based on the expected return of the asset portfolio. However, public plans will now also disclose the market value of the liability (LDROM) using a discount rate tied to high-quality bond yields. This LDROM liability value will introduce mark-to-market volatility as the LDROM will go up and down as bond yields change (and vice versa).
What it could mean to investment portfolios
For municipal bond investors, it's too early to tell how this might affect the perceived risk/return of a given investment. Pension deficits and funding can have a large impact on the creditworthiness of state and local bond issuers, and investment analysts keep a keen eye on pension obligations. Since the LDROM is not a change to accounting and funding rules—it's merely an additional disclosure—we expect no immediate effects on the municipal bond market. However, as ratings agencies and investors digest LDROM disclosures, they may begin to prefer those pension plans with investments that better track the liability.
For public plans, this presents an opportunity to tweak their bond portfolio. Broad-based portfolios will likely give way to more tailored bond portfolios that help meet specific outcomes.
For example, public plans have very long investment horizons because their plans are typically open to new members. They use this to their advantage by investing in assets with higher expected returns, which are typically more volatile (such as public equities) or less liquid (such as private markets). At the same time, the pension plan still has short-term obligations in the form of benefit payments to members and capital calls from their private market asset managers. A bond portfolio could be devised to meet both short- and long-term needs:
A) A portion could be allocated to ensure short-term liquidity needs are met, thereby allowing riskier assets time to ride out downturns and harvest risk premia.
B) The remaining fixed income allocation could be allocated to longer-dated bonds. This has three benefits:
Longer bonds have higher yields than shorter bonds when the yield curve is upward sloping. This could be an added source of return.
Longer bonds are a better match to the LDROM, thus helping the portfolio move a bit more like the LDROM valuation over time.
Longer bonds offer greater duration. In times of economic downturns, risky assets like equities and credit tend to fall while rate-sensitive assets tend to rally. More duration provides more macroeconomic diversification.
Putting these two ideas together, the bond portfolio could be reconfigured to a barbell strategy of short-term and long-term bonds. The message for pension plan sponsors? Don't call it LDI. Call it better bonds.
Andy Hunt is a senior investment strategist and head of Fixed Income Solutions at Allspring Global Investments. In this capacity, he leads the development and execution of fixed income solutions across Allspring Global Investments' client base, with a particular focus on institutional clients and liability-driven investing solutions. Prior to this, he served as head of North American solutions at BlackRock for corporate pensions plans, including U.S. liability-driven investment capabilities. Andy began his investment industry career in 1992. Andy earned a bachelor's degree in mathematics from Cambridge University.
Jonathan Hobbs is the head of U.S. solutions for the Systematic Edge Investment Solutions team at Allspring Global Investments. In this capacity, he designs and implements outcome-oriented investment portfolios. Prior to this, he served as head of client solutions, San Francisco, and co-head of LDI North America for BlackRock. He began his investment industry career in 2003. Jonathan earned a bachelor's degree in actuarial science/finance from Drake University.
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