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CASE STUDY

Building a better benchmark for a large corporate plan

Client profile

  • Financial services multinational
  • Around $10 billion in U.S. qualified plan assets
  • Focus on liability-driven investing (LDI) for pension assets
  • More than 70% of pension plan assets invested in fixed income securities

The plan sponsor wanted to know

  • Would a proposed benchmark for the fixed income portion of the plan be appropriate?
  • Would the proposed benchmark align with the sponsor's LDI objectives, helping it to meet future benefit obligations to employees?
  • Could an alternative benchmark achieve these objectives more effectively?

Objective

Find the best benchmark for the plan

Benchmarks help guide the investments that pension plans make to fund future benefit payments to employees. The client — a corporate plan pursuing a liability-driven investing (LDI) approach — asked us to determine whether a proposed fixed income benchmark would fulfill the plan sponsor's requirements. If not, we were asked to develop an alternative benchmark.

 

The sponsor had three key criteria for a benchmark:

  • The benchmark's yield should equal or exceed the discount rate that the plan used to determine the current value of future benefit payments
  • The benchmark's duration, or sensitivity to changes in interest rates, should align with the duration of the plan's liabilities
  • The benchmark's credit quality should align with the credit quality of the plan's liabilities, given a high-quality U.S. corporate bond discount rate

 

This case study is shown for illustrative purposes only. It does not represent an offer or recommendation for any benchmarking approach.

RESEARCH

Challenges with the proposed benchmark

1.

Our analysis found there was a significant mismatch in sector exposure between the proposed benchmark and the hypothetical portfolio used to determine the plan's liability discount rate. The benchmark had a large exposure to bonds of government agencies and local authorities through its 40% weighting in the Bloomberg U.S. Aggregate AA Index, while the liability discount rate did not include these bonds.

2.

Bonds rated AA made up more than 50% of the proposed benchmark. A limited universe of such bonds increases concentration risk and makes it more challenging for active investment managers to add value through security selection. 

3.

Just 25% of the proposed benchmark was allocated to the Bloomberg U.S. Long Credit Index (bonds with 10+ years to maturity). These long bonds play an out-sized role in determining the plan’s liability discount rate.  Also, similarly to the liability, long bonds are relatively sensitive to changes in interest rates.

SOLUTION

Our alternative benchmark is tailored to the client's criteria

Given the shortcomings of the proposed benchmark, we constructed an alternative benchmark that met the plan sponsor's three criteria and addressed our key concerns.

 

U.S. investment-grade corporate bonds accounted for 75% of our alternative benchmark, providing broad exposure to the asset class. For the remainder, we included a 25% exposure to U.S. Treasury bonds, an extremely liquid and safe sector. This provided both high credit quality aligned with the discount rate and greater exposure to longer-duration bonds, which better matched the long duration profile of the pension plan's liabilities.

Given the shortcomings of the proposed benchmark, we constructed an alternative benchmark to meet the plan sponsor's three criteria and address our key concerns.

U.S. investment-grade (BBB/Baa and above) corporate bonds accounted for 75% of our alternative benchmark, providing broad exposure to the asset class. For the remainder, we included a 25% exposure to U.S. Treasury bonds, an extremely liquid and conservative sector. This provided both high credit quality aligned with the discount rate and greater exposure to longer-duration bonds, which better matched the long duration profile of the pension plan's liabilities.

Key takeaways

The plan sponsor asked us to analyze a proposed benchmark

This U.S. defined benefit plan sought a benchmark for its fixed income assets that would better align the plan's assets with the liability discount rate used to value its pension obligations. The liability discount rate was based on the yield of a hypothetical portfolio of high-quality U.S. corporate bonds that matched the plan's projected cash flows.

Our analysis found the proposed benchmark fell short

The client's proposed benchmark included exposure to government agency bonds with no counterpart in the hypothetical portfolio underlying the liability discount rate. In addition, the benchmark had sizable exposure to a constrained, less-liquid universe of AA-rated bonds. And it lacked sufficient exposure to longer-term bonds that better matched the plan's long-dated liabilities.

Our alternative benchmark aimed for better alignment

Our benchmark sought to provide close alignment with the liability discount rate, while focusing on high credit quality. The benchmark featured a more liquid pool of securities that active investment managers can use to build and manage a portfolio. A larger opportunity set, more diversification and improved liquidity should potentially lead to better active management outcomes.

Bloomberg U.S. Aggregate AA Index represents the AA-rated component of the U.S. investment-grade fixed-rate bond market. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of sales charges, commissions, account fees, expenses or U.S. federal income taxes.

Bloomberg U.S. Long Corporate AA Index is a market-value weighted index that tracks the total return results of publicly issued AA-rated U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements, with maturities of 10 years or more. To qualify, bonds must be SEC-registered and must be an investment grade security. This index is unmanaged, and its results include reinvested distributions but do not reflect the effect of sales charges, account fees, expenses or U.S. federal income taxes.

The Bloomberg U.S. Government Index includes U.S. dollar-denominated, fixed-rate, nominal U.S. Treasuries and U.S. agency debentures (securities issued by U.S. government owned or government sponsored entities, and debt explicitly guaranteed by the U.S. government).

Bloomberg U.S. Long Credit Index is a market-value weighted index that tracks the total return results of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements, with maturities of ten years or more. To qualify, bonds must be SEC-registered and must be an investment grade security. This index is unmanaged, and its results include reinvested distributions but do not reflect the effect of sales charges, account fees, expenses or U.S. federal income taxes.

Bloomberg U.S. Credit Index is a market-value weighted index that tracks the total return results of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered and must be an investment grade security. This index is unmanaged, and its results include reinvested distributions but do not reflect the effect of sales charges, account fees, expenses or U.S. federal income taxes.

A pension plan's liability discount rate is used to calculate the present value of future benefit payments.

Duration refers to a bond or index's sensitivity to changes in interest rates.

Credit quality is a measure of a debt issuer's ability to make all contractual interest and principal payments.

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor's, Moody's and/or Fitch, as an indication of an issuer's creditworthiness.
The indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
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