Pension Insights
Presented by Nuveen Asset Management’s Institutional Solutions Group
July 19, 2016
TURN THOSE MACHINES BACK ON!
Welcome to Pension Insights, Nuveen Asset Management’s monthly pension newsletter. Pension Insights addresses
critical issues faced by U.S. corporate defined benefit pension plans and provides tactical and strategic investment
ideas for plan sponsors.
In this issue, “Turn Those Machines Back On!” our Flash Commentary discusses how geopolitical events and market
volatility affect pension plans. Our Pension Idea proposes hedging interest rate risk using physical long bond
allocations and gaining equity exposure through derivatives. And, as always, we present our Funded Ratio Tracker
results, which provide historical, current and forward-looking views of a typical plan.
As we plan future issues, we’d love to hear from you as well. Let us know what challenges you are facing and what topics
you would like to hear more about. Feel free to contact me directly at [email protected] or (312) 917 – 6826.
David R. Wilson, CFA
Head of Institutional Solutions Group
Nuveen Asset Management, LLC
Falling Rates Drag on U.S. Corporate Funded Ratio
Nuveen Asset Management’s Funded Ratio Tracker shows the month-to-month funded ratio changes of a typical U.S. corporate defined benefit pension
plan, as well as forward-looking scenarios based on current Nuveen Asset Management forecasts and reasonable upside / downside scenarios. We track two
separate funded ratios– an “Actual,” which accounts for non-market items such as contributions, service cost, and benefit payments, and a “Market,” which
focuses on the funded ratio changes due only to interest rates, spreads, and asset returns.
The Nuveen Asset Management Funded Ratio Tracker ending June 30, 20161
100%
74% (Actual)
71% (Market)
Scenario2 (6-Months Forward)
Return-Seeking Assets
Interest Rates
Funded Ratio
Upside
+10%
+100 bps
85%
Baseline
+5%
+50 bps
79%
Downside
-10%
-50 bps
69%
Please note: Different assumptions and market conditions may result in significantly different outcomes.
Pension Insights
July 19, 2016
Funded Ratio Attribution — Changes during June 2016
Assets: Rose by 1.5% in June with gains in most
asset classes. Fixed income was the major driver
with real estate and commodities boosting
performance further.
Liabilities: The discount rate declined by 20 bps
and liability values increased 3.8%.
Funded Ratio: Liabilities increased more than
assets in June, leading to a month-over-month
decrease in the funded ratio of approximately 1.6%.
Year to Date: Liabilities rose by 11.3%, driven by
a decline in the discount rate of 80 bps. Assets
rose 5.6%, led by gains in fixed income and
domestic equities. The market effect on funded
status was a decrease of 3.9%.
Current Nuveen Asset Management Forecasts
Equities: Bob Doll, Nuveen Asset Management’s Chief Equity Strategist, believes equities are no longer as cheap as they once were. But he
thinks valuations are still reasonable, especially compared to bonds and cash. He expect the global economy to improve unevenly, which
should help corporate earnings recover. If this occurs, equities should be able to move unevenly higher. The pace of gains, however, is likely to
be slower than what investors experienced during the first six years of this bull market. Within the equity market, he prefers mid-cycle cyclicals,
companies that can generate positive free cash flow and those with higher levels of domestic earnings. Read More
Fixed Income: Tony Rodriguez, Nuveen Asset Management’s Co-Head of Fixed Income, believes the Fed will most likely leave rates unchanged
and use forward guidance to keep monetary policy and financial conditions accommodative. While heightened uncertainty and volatility will
likely persist, we believe modestly positive domestic growth coupled with the gradual pace of policy normalization should support the credit
sectors. He continues to focus on driving returns using income and security selection within the credit-related sectors of investment grade
corporates, high yield bonds and preferred securities. Read More
Volatility: James Colon, Head of Managed Volatility Strategies for Nuveen Asset Management, is forecasting elevated levels of surplus
volatility for corporate defined benefit plans following the UK’s EU referendum vote (i.e., Brexit). The results surprised global markets, leading
to a surge in surplus volatility at the end of June. The surplus volatility of a typical fully-funded defined benefit plan finished the month at
19.8%. The Institutional Solutions group is forecasting a modest decline in surplus volatility in July as markets integrate the news.
Flash Commentary: Turn Those Machines Back On!
By David R. Wilson, CFA
In the 1983 movie, Trading Places, the Duke Brothers’ scheme to manipulate the frozen concentrated orange juice market was
turned against them by a cleverer Luis Winthorpe III and Billy Ray Valentine, who cunningly provided them with an incorrect
crop report. As the Dukes realized they were duped, panic ensued but their fate was already sealed. The market closed, and as the
Duke brothers’ trading partners surrounded them to settle margin calls, Mortimer Duke bellowed, “Turn those machines back on!”
Pension Insights
July 19, 2016
I couldn’t help but feel the Dukes’ pain on the evening of June 23, 2016, when it became apparent that the Leave vote would
prevail in the Brexit saga. Investors around the globe were caught off-guard by the result, sure in their thinking that the U.K.
would never vote to leave the European Union. In fact, despite the polls leading up to the vote showing a toss-up, I read in
numerous publications stating there was “a 70% chance” Remain would prevail. So, the market “got it wrong” and U.S. investors
retreated to their bunkers to weather the impending financial storm.
A few days later, U.S. investors emerged from the darkness to partly-sunny and calm skies. After falling 5.3% over the following
two days, the S&P 500 rebounded sharply and regained almost all losses by July 1st before rising to new highs in the early days of
July. Furthermore, equity volatility, as measured by the VIX Index, spiked from 17.25 to 25.76 (a 49.3% rise) before snapping back
to a level that is actually lower than pre-Brexit at 14.76 (as of July 7th). It was almost enough to allow investors to forget that the
Brexit vote actually happened. However, there was one market that rallied hard and did not reverse course. And this was the
market that produced the worst news of all for U.S. corporate pension plans: U.S. Treasury yields plummeted to record lows.
The 30-year U.S. Treasury bond’s yield-to-maturity has declined from 2.56% to 2.14% (a 16.4% drop) since the Brexit vote, as of
the date of this writing. Since U.S. corporate plan liabilities are discounted using high-quality corporate bond yield curves and
most corporate plans are net-short duration (i.e. the duration of their assets are shorter than the duration of their liabilities), such a
precipitous drop in long-term interest rates further propelled liability values higher and funded ratios lower. In fact, according to
our Pension Tracker, liability values increased by 4% due to long-term interest rates increasing as of June 30th and continued their
march higher since then.
U.S. corporate plans are typically exposed to two primary risk factors – equity beta and long-term interest rates. In the case of
equities, an asset class that is generally uncorrelated with pension liabilities, we got lucky. However, we were burned by falling rates
yet again. Brexit is just another reminder that many plans’ asset allocations are significantly exposed to geopolitical events and
market volatility. The time for a more liability-aware allocation is long overdue.
Pension Idea: How to Have Your De-risking and Eat Your Equity Cake Too!
By Evan Inglis, FSA, CFA
Most pension plan sponsors need to get some exposure to growth assets like equities to try to reduce their long-term costs. At the
same time, they are worried about interest rate risk, leading some plan sponsors to use interest rate futures or interest rate swaps to
reduce this risk. Futures and swaps are derivatives that provide leveraged exposure to interest rates, so only a small amount of
capital is needed to generate significant interest rate exposure to offset rate risk in the pension plan. That saves capital for other
investment objectives. However, we think it makes sense to consider exactly the opposite approach! Why not get your equity
exposure with derivatives?
Because interest rate risk is so significant for pension plan investors, it makes a lot of sense to eliminate it to the greatest extent
possible. The best way to do that is with a portfolio of mostly corporate bonds (along with some Treasuries to fill in gaps along the
yield curve) that have maturities that align with the expected pension payments. When the maturities align, interest rate risk can
be reduced along the yield curve. It makes sense to do this because the interest rate risk being taken by pension investors is not
being compensated with higher expected returns. It also makes sense because it may soon become challenging to find long
corporate bonds (for details, see our new white paper, Long Bonds for the Short Run).
Pension Insights
July 19, 2016
Once you’ve dealt with interest rate risk through a liability-matching long bond allocation, you can gain exposure to equity returns
in the derivatives market. With equity futures - the easiest and most common approach - investors are essentially borrowing
money at a short-term rate and then investing it in the equity market. There are risks in this approach, but it makes a lot more
sense than borrowing money at a higher long-term rate and investing in the equity market. And that is exactly what pension
investors are doing today! The pension benefits they’ve promised are a long-term debt that has been loaned at a long-term
corporate bond rates. By immunizing that debt first with a matching portfolio of bonds, it allows a pension investor to enter into a
more sensible transaction by using equity futures.
Pension investors who are taking interest rate risk with investments that do not match their liability are making huge bets on
interest rates. This looks like a good bet while rates are at historic lows, but those bets will be lost if rates drop, stay the same or
only rise slowly and gradually in the future. At Nuveen, we regularly trade futures for some of our strategies and we have the
capability to help plan sponsors, large and small, implement this approach.
Related Research
A Mid-Year Assessment of Our Ten Predictions
Bob Doll takes a look at the predictions he made at the beginning of the year and
provides a mid-year scorecard.
Robert C. Doll, CFA
Chief Equity Strategist
Nuveen Asset Management, LLC
Long Bonds for the Short Run
Will the supply of long corporate bonds be sufficient to meet demand for corporate
pension funds?
Evan Inglis, FSA, CFA
Senior Actuary
Nuveen Asset Management, LLC
Brexit: Short-Term Thoughts, Longer-Term Implications
The Citizens of the United Kingdom (UK) voted to leave the European Union (EU).
The markets had anticipated that the UK would vote to stay in the EU, so the surprise
voting results immediately drove strong movements in markets.
Tony Rodriguez
Co-Head of Fixed Income
Nuveen Asset Management, LLC
Pension Insights
July 19, 2016
The Case for Global Utilities
We believe the global utilities sector offers attractive features.
James Clark, CFA
Client Portfolio Manager
Nuveen Asset Management, LLC
Upcoming Events
Date
Location
Event
July 31
Manchester
Village, VT
IMI Endowment & Foundations Forum
August 21-23
New Haven, CT
NCPERS Public Pension Funding Forum – Dave Wilson speaking on demographic-based asset allocation
September 15
Minneapolis, MN
Great Plains Institutional Investor Forum – Dave Wilson speaking on multi-asset class portfolios
October 6
Seattle, WA
Pacific Northwest Institutional Investor Forum – Dave Wilson speaking on an asset allocation panel
Pension Insights
July 19, 2016
IMPORTANT DISCLOSURES
This material is provided for informational purposes for plan sponsors and represents the opinion of Nuveen Asset Management, LLC (“NAM”) and is not intended to be a forecast of future
events and there is no guarantee of any future result. It is not intended to be provide specific advice and should not be considered investment advice of any kind. Information was obtained
from third party sources which we believe to be reliable, but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell specific
securities or investment products.
The specific risks identified will be dependent on the asset classes identified in the “typical plan.” NAM does not guarantee any minimum level of investment performance or the success of
any investment strategy. Diversification does not ensure against loss.
It is important to review investment objectives, risk tolerance, liquidity needs, tax consequences and any other considerations before choosing an investment style or manager. Certain
information was obtained from third party sources, which we believe to be reliable but not guaranteed for accuracy or completeness.
Asset Class Related Risk: Different types of asset investments have different types of risks, which may provide higher returns but also greater volatility. In general, equity securities tend to
be more volatile than fixed income securities. Foreign investments may involve exposure to additional risks such as currency fluctuation and political and economic instability. Small- and
mid-cap investments involve higher volatility than large-cap companies. International investments may involve exposure to additional risks such as currency fluctuation and political and
economic instability. The value of, and income generated by, debt securities will decrease or increase based on changes in market interest rates. As interest rates rise, bond prices fall.
However, there are other factors that can contribute to how securities react in various interest rate environments. The value of a REIT can be hurt by economic downturns or by changes in real
estate values, rents, property taxes, interest rates, tax treatment, regulations, or the legal structure of the REIT. Except in certain circumstances, income is generally subject to both federal
and state taxes. Income is only one component of performance and an investor should consider all of the risk factors for each asset class before investing. Infrastructure-related securities
may involve greater exposure to adverse economic, regulatory, political and legal changes. Derivatives (such as futures and options) involve substantial financial risks and transaction costs.
A long/short strategy is a speculative technique and may magnify gains and losses and increase volatility. Preferred securities combine the features of bonds and stocks, and have credit risk
based on the issuer’s ability to make interest and dividend payments when due. Except in certain circumstances, income is generally subject to both federal and state taxes.
1Methodology
for Calculating the Nuveen Funded Ratio Tracker: The Nuveen Asset Management Funded Ratio Tracker (“NFRT”) was established on September 30, 2014, is calculated
monthly and is meant to illustrate the month-to-month funded-ratio changes of a typical U.S. corporate defined benefit plan. The NFRT is calculated by dividing the value of the plan’s assets
by the present value of the plan’s liabilities at each month end. The Market Funded Ratio Tracker includes changes due to asset returns and corporate bond yields only. The Actual Funded
Ratio Tracker recognizes the additional change due to contributions, service cost and benefit payments. The NFRT’s history begins on 12/31/2007 with an assumed funded ratio of 106 – the
approximate aggregate funded status of pension plans sponsored by Fortune 1000 companies at that date.
Calculation of asset returns: At each month end, NAM calculates the plan asset return using a set of asset class weights provided by Greenwich Associates and corresponding market
indices NAM believes best represent the asset class exposures. Greenwich Associates derives the asset class weights from an annual survey they conduct of over 500 U.S. corporate defined
benefit plans. At the end of January of each year, NAM begins using the new asset class weights and assumes month-end rebalancing to these weights.
Asset Allocation: Asset class returns are based on returns of the following representative indices: U.S. Equities – S&P 500 Index, International Equities – MSCI All Country World U.S. Index,
Long Duration Fixed Income – Barclays Long Government-Credit Index, Aggregate Fixed Income – Barclays Aggregate Bond Index, Real Estate – Dow Jones U.S. REIT Index, Hedge Funds –
HFRX Global Hedge Fund Index, Private Equity – Thomson Reuters Private Equity Buyout Index, Commodities – Bloomberg Commodity Index, Cash – Barclays 3-Month T-Bill Index.
Calculation of plan liability returns: NAM uses a static set of hypothetical pension plan cash flows that are intended to represent a typical U.S. pension plan. As of 2015, the duration of the
liability represented by the cash flows is 13.5 years and about 40% of the liability is for retirees. Each month we add interest to the prior month liability based on the single effective interest
rate used to measure the liability in the prior month. We determine a change in liability due to rate and spread changes by applying a corporate yield curve for the current month and prior
month to the hypothetical cash flow stream. The cash flow stream was adjusted as of January 31, 2015 to represent a change in mortality assumption from RP-2000 tables to RP-2014
tables. NAM uses the discount curve underlying the Merrill Lynch Pension Liability Indices to determine liability values and single equivalent interest rates.
Actual Funded Status Tracker: In order to determine the funded ratio for the Actual Funded Ratio Tracker, adjustments to the Market Funded Ratio Tracker are made for actual
contributions, service cost and benefit payments in order to estimate actual funded status for a typical U.S. pension plan. The adjustments for these factors are made at the end of each year
and are developed from data published annually by Towers Watson.
2
Scenario Methodology: The three Funded Ratio Tracker scenarios represent three possible paths for return-seeking assets and interest rates over the following six month, Based off of the
Actual Funded Ratio. We begin by calculating the monthly returns for return-seeking assets implied within each scenario. Using the duration and average coupon of the hedging assets as of
the prior month end, we then calculate the monthly returns of the hedging assets assuming a parallel shift in interest rates. To calculate the ending asset value for each scenario, we carry
forward the assets using the returns previously calculated, the asset allocation as of the prior month end (described in the Funded Ratio Asset Allocation section above), and the monthly
benefit payment assumed by the Funded Ratio Tracker. The liability values are then calculated by shifting the Merrill Lynch Pension Liability Curve as of the current month end by the
amount indicated in the scenario, with a minimum yield of 0%. The Funded Ratio Outcome is the ending asset value divided by the ending liability value for each scenario. Please note:
different assumptions and market conditions may result in significantly different outcomes.
The Nuveen family of indexes (“Indexes”) are based on a methodology designed by Nuveen Asset Management, LLC and are Powered by Wilshire. Wilshire calculates and distributes the
Indexes based on the third-party supplied methodology. Wilshire makes no representations about the intended purpose or the methodology used to construct the Index.
Nuveen Investments is an operating division of TIAA Global Asset Management. Nuveen Asset Management, LLC is a registered investment adviser and subsidiary of Nuveen Investments,
Inc. For more information, please visit the Nuveen Investments website at www.nuveen.com.
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