Liability-Driven Investing. Seeking A Balance Between Risk & Return In An Uncertain World. Manulife Asset Management. Spring ManulifeAM.

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1 Liability-Driven Investing Seeking A Balance Between Risk & Return In An Uncertain World Manulife Asset Management Spring 2017 ManulifeAM.com

2 Executive Summary For many pension plan sponsors, November 2016 was a month to remember. In the space of 30 days, the estimated aggregate funding deficit of pension plans sponsored by S&P 1500 companies fell by 20%, bringing the aggregate funded status to 81% 1. The sharp decline can be attributed to the rise in discount rates 2 after the US Presidential Election Donald Trump s victory has prompted a rise in inflation expectations as investors anticipate a swathe of tax cuts and increased fiscal spending. This also supported continued expectations for the US Federal Reserve to continue normalizing interest rates. Few would disagree that the reduction in aggregate funding deficit 1 is a positive development. However, this does not mean sponsors challenge to meet their future obligations is over. As of February, the estimated aggregate funding deficit of plans sponsored by S&P 1500 firms stood at a hefty US$400 billion 3. We believe this is a good time for sponsors to take another look at their de-risking strategies to lock-in the improvement in funding status and ensure that they have adopted the best framework to meet the challenges of the future. In this paper, we shall attempt to contextualize the current macroeconomic environment and identify events that we believe bear monitoring. We will also review the Liability Driven Investing (LDI) framework, explain how it could help sponsors manage funded status volatility and why inaction could be costly. Serge Lapierre, FSA, FCIA Global Head of Liability-Driven Investments Research 1 Mercer: S&P 1500 Pension Fund Deficits Reduced By 20 Percent Following US Election, December 6, The present-day value of future obligations falls when interest rate rises 3 Mercer, March 8, For Institutional/Investment Professional Use Only. Not For Distribution To The Public.

3 Macro Outlook: Volatility May Be Low, But Uncertainty Rules Supreme Optimism and hope two words that characterized the financial markets in the first three months of The S&P 500 index logged its biggest quarterly gain since the end of Meanwhile, Barron s noted that the first quarter of the year was among the least volatile in nearly half a century 5. On the surface, things seem not just calm, but arguably, good. S&P 500 Index Jan 15 Mar 15 May 15 Jul 15 Sep 15 Nov 15 Jan 16 Mar 16 May 16 Jul 16 Sep 16 Nov 16 Jan 17 Mar 17 Source: Bloomberg, as of March 31, 2017 However, appearances can be deceiving. As our Chief Economist Megan Greene wrote in a recent note, uncertainty continues to rule supreme 6. Investors have become more bullish about growth, inflation and rate projections since last November in anticipation of the new administration s growth-supportive policies. But in the absence of policy reforms that fundamentally boost long-term productivity in the US, she believes the US is a 2% growth economy 6. Our Chief Economist likens the impact of any forthcoming stimulus measures to temporary sugar hits and notes that they are, for the most part, likely to be smaller than the markets have come to expect. She also notes that the effect could take longer to filter through to the real economy than expected. Growth, inflation and rates might tick up moderately on the back of initiatives that the new administration is pursuing, but she believes the magnitude of the change would be moderate. Upcoming elections in Europe are also likely to be a source of uncertainty for investors. French voters will choose their President in May from a group of candidates that includes an anti-european candidate who could well win the first-round of the two-stage election 7. Meanwhile, Germany will decide whether to support Angela Merkel s bid to run as Chancellor again in September and Italy will hold a general election by May 2018, with a populist, anti-euro party currently leading opinion polls 8. 4 Bloomberg, April 3, Barron s: The Least Volatile Quarter On Record Since The 1960s, March 31, Manulife Asset Management, April 3, Telegraph, April 7, Globe And Mail: Italy s Five Star Movement Is On The Rise As Populism Falters In Europe, March 26, For Institutional/Investment Professional Use Only. Not For Distribution To The Public.

4 The outcomes of the French and Italian elections, in particular, could have a significant influence on the future of the European Union given that the possible victors in both countries are seeking to lead their countries out of the common currency. In addition, Brexit is finally underway now that the UK has triggered Article 50. It is still unclear whether the UK will have a deal on its new relationship with the EU at the end of the two-year negotiating period, but our economics team believes there is a significant chance it will not. This could impact not just the UK economy but also that of the EU in addition to creating volatility in financial markets globally. Finally, it is important to recognize that we continue to live in a low-yield, low-return world. The markets might have chosen to embrace optimism in the short-term, but structural issues confronting the global economy remain: a global debt overhang, low productivity, a lack of aggregate demand and unfavorable demographics. These factors will continue to weigh on growth. Ultimately, in the absence of realistic means to resolve these structural issues, we expect US GDP growth to average around 2% in the next five years and the Eurozone to post growth of around 1.5% in aggregate over the same period 6. De-Risking: Taking A Long-Term View The sense of optimism that has characterized the markets can be infectious. However, plan sponsors are long-term investors who need to cast their eyes firmly into the future. Crucially, they need to ensure that their projection of future obligations reflects advancements in technology/healthcare as well as changes in life expectancy, interest rates and inflation expectations. This perhaps explains why sponsors have increasingly been paying attention to LDI an investment framework that uses a pension plan s liabilities to replace public market indices as the benchmark against which it measures investment performance. The underlying rationale is relatively straightforward: financial markets move to their own rhythm, independent of a plan s obligations. It is therefore very difficult for a plan that benchmarks its portfolio against a public market index to expect to be able to match its specific liabilities in a consistent and reliable manner. Selecting an appropriate benchmark is critical for sponsors because the economic risk profile of a pension plan can be different from its liability risk profile. With this in mind, it is perhaps not surprising that the LDI framework is built around the concept of liability matching. Under such a framework, a plan would typically split its portfolio into two: Hedged Portfolio a hedging portion that matches a plan s liabilities, typically comprising fixed income instruments as well as other income-generating assets; and Growth Portfolio a return-seeking or growth portion could help to narrow any gap in a plan s funded status 4 For Institutional/Investment Professional Use Only. Not For Distribution To The Public.

5 The LDI Framework: A Change In Perspective Traditional Framework LDI Framework Bonds Domestic Equity International Equity Hedged Portfolio Other Money Market Growth Portfolio Source: Manulife Asset Management, April 7, 2017 Typically, one begins the de-risking process by first determining the proportion of liabilities that needs to be hedged (thereby establishing the hedge ratio ). The remaining assets would be invested in a diversified portfolio of return-generating growth assets. In the LDI universe, success can be roughly defined as the degree to which sponsors are able to meet their goal of being fully funded within a set timeframe. When implemented correctly, these strategies can enable plans to place a cap on overall risk exposure. The LDI framework makes it possible for sponsors to manage their investments in a way that prioritizes the long-term while reducing funding volatility. At the same time, plans can seek to improve their funded-status via their Growth Portfolio. It is worth noting that allocating assets to the Growth Portfolio will only be effective if returns exceed the discount rate of the liabilities. It could also increase the funded status volatility of the plan in the short- term. Plan sponsors must therefore balance the long-term benefits of investing in growth assets with the short-term volatility that they could bring. 5 For Institutional/Investment Professional Use Only. Not For Distribution To The Public.

6 Capturing Alpha: A Dynamic Approach to De-Risking As mentioned earlier, plan sponsors are strategic investors and tend not to stray too far from what they perceive to be their optimal long-term asset allocation plan. However, it is often worth re-assessing their existing approach and ascertain if other investment frameworks could be more efficient at helping them to achieve their goals. An approach that we believe could be helpful is the Dynamic Asset Allocation framework, which enables sponsors to adjust the level of allocation between the Hedged Portfolio and the Growth Portfolio over time. Many plans have chosen to adopt a de-risking glide path to help them decide precisely when they should adjust their allocation between the two portfolios. In its simplest form, a de-risking glide path is a blueprint that maps out when a plan should increase allocation to their Hedged Portfolio as different conditions are met on its path towards a fully-funded status. Typically, the three most common conditions, or triggers, used in a glide path are funding ratio, interest rate levels and time. One key advantage of the Dynamic Asset Allocation framework is that it allows plans to lock-in the alpha extracted from the Growth Portfolio by transferring them to the Hedged Portfolio as gains are realized. This also means that when sponsors inject cash to fund deficits, the injected funds would be protected as the bulk of it would (more likely than not) be allocated to the liability-replicating portfolio. The following hypothetical example 9 illustrates how a typical pension plan would fare under a traditional asset allocation framework versus a Dynamic Asset Allocation model. Traditional Asset Allocation vs. Dynamic Asset Allocation: An Illustration 9 Hedged Portfolio - Bonds Growth Portfolio - US Stocks Growth Portfolio - International Stocks Source: Manulife Asset Management, April 5, 2017 Pension Plan XYZ, which has an initial funded ratio of 90%, has allocated 40% of its assets to its Hedged Portfolio. It has distributed the rest of its assets equally into two asset classes US stocks and international equities. The plan s sponsors have adopted the Dynamic Asset Allocation strategy and plan to increase the liability hedge ratio by 2% for every 1% increase in its funded ratio. 9 Characteristics, guidelines and constraints cited are for illustrative purposes only. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. 6 For Institutional/Investment Professional Use Only. Not For Distribution To The Public.

7 The following two charts illustrate how the plan can be expected to perform under the two models: traditional asset allocation versus Dynamic Asset Allocation 10. Funding Ratio 115% 110% 105% 100% 95% 90% 85% 80% Year Traditional Strategy Dynamic Asset Allocation Source: Manulife Asset Management, April 5, 2017 The graph above shows that XYZ s plan would experience much lower funding ratio volatility if it had adopted the Dynamic Asset Allocation framework as opposed to the traditional allocation strategy. This is because the dynamic asset allocation approach allows plans to manage the level at which liabilities are hedged. By contrast, sponsors do not get a say under the traditional approach the market decides. Staying with the example, the graph below is also interesting it illustrates XYZ s hedge ratio s relatively smooth progress towards its targeted funding level (hedge ratio) under the Dynamic Asset Allocation framework. By contrast, XYZ s hedge ratio would have simply moved in line with the market if it had applied the traditional approach. Hedge Ratio 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Year Traditional Strategy Dynamic Allocation Strategy Source: Manulife Asset Management, April 5, Traditional strategy is rebalanced monthly to target allocation. Dynamic allocation strategy is rebalanced monthly to achieve dynamic target hedge ratio. 7 For Institutional/Investment Professional Use Only. Not For Distribution To The Public.

8 The chart below shows how XYZ s plan could be expected to perform over 10 years from a funding perspective 10. Impact Of Dynamic Asset Allocation Strategy On Funded Ratio Over 10 Years 100% Lower contributions to fund deficits 80% 60% 40% Better funded position if things don t turn out as expected 20% 0% Traditional Strategy Dynamic Asset Allocation Funded Ratio w/o Additional Contribution Additional Contribution Source: Manulife Asset Management, April 5, 2017 The chart above shows that XYZ can be expected to achieve its goal of being nearly fully funded in 10 years regardless of which strategy it had chosen. But there is one key difference: the Dynamic Asset Allocation strategy can provide XYZ with the option to make lower contributions to its plan should things fail to work out as expected. Enhancing Returns While Keeping Risks Down As stated previously, although inflation expectations have risen since last November, we continue to live in a low-yield, low-return world. It is a reality that continues to pose challenges for plan sponsors. Central bank policies in the years after the Global Financial Crisis have not helped plans found themselves in the peculiar position of competing against central banks for the same assets, driving yields lower 11. This has led to concerns that plans could be forced to raise the risk profiles of their portfolios in the hope that higher yielding assets can help them to meet their obligations. One way of mitigating this risk is for sponsors to consider allocating a portion of their Hedged Portfolio to a diversified set of asset classes that are complimentary in nature to their bond portfolio. Assets that could fit the bill include real estate, infrastructure, timber, agriculture and absolute return strategies. Ideally, these assets should have a low correlation to those held in the Growth Portfolio. The end objective is to create a diversified Hedged Portfolio that is well-aligned with a plan s obligations. 11 BIS: How Much Should We Read Into Shifts In Long-Dated Yields, March 3, For Institutional/Investment Professional Use Only. Not For Distribution To The Public.

9 LDI: An Evolving Framework What we have provided so far is a quick overview of the LDI framework and how sponsors could incorporate it into their overall de-risking strategy. However, it must be said that the framework is constantly evolving. Where it used to be perceived as being the preserve of larger plans (due to the associated operation and governance structure that are typically required), the possibility of outsourcing specific portions of the process has made LDI more accessible to smaller plans. Customization is also increasingly common place as sponsors become more familiar with the concept. Conclusion One refrain that we hear fairly frequently is that sponsors are uncomfortable with the idea of implementing an LDI program when interest rates are so low. Some have expressed a preference to wait for interest rates to rise before acting a view that, at first glance, makes perfect sense. The Federal Reserve is expected to raise rates up to three times in 2017 after all. However, this perspective does not take into account the fact that by choosing to wait for interest rates to rise, one would have by default chosen to embrace equity risk as well as interest rate risk. The implication here is that a plan s funded status could deteriorate if markets do not behave as expected. Staying on the sidelines can feel safe, but it comes with hidden risks. Inaction is an active decision in itself. While one may be hard-pressed to define what could be considered to be the perfect moment to implement LDI or de-risking strategies, we believe there is no wrong time to draw up a plan for the future. 9 For Institutional/Investment Professional Use Only. Not For Distribution To The Public.

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