Carol McFate is the chief investment officer of Xerox Corporation, where her team is responsible for the investment management of roughly $9 billion in defined benefit and defined contribution investments for North American plans. Since November 2006, she has built a team and successfully in-sourced the management of the investment managers for Xerox’s U.S. qualified retirement plans. She is also a Trustee of the Xerox UK Pension Plan. Prior to Xerox, McFate spent more than 20 years in various executive roles at large corporations, including AIG, Inc., XL Capital Ltd. and Prudential Financial.
McFate was recently named on Trusted Insight’s list of the Top 30 Corporate Chief Investment Officers. She spoke with Trusted Insight on October 24, 2016.
Trusted Insight: You've spent much of your career in treasurer roles, particularly at insurance companies. Can you tell me how those experiences informed your investment philosophy and your leadership style at Xerox?
Carol McFate: Having been an insurance company Treasurer, I came in with the mindset of investing against the liability, at least from the defined benefits side. I've always viewed every professional role I've had as a risk manager.
In this particular CIO role, my goal is to build a portfolio of liability-aware and risk-aware investments that match the liability. Today the challenge is, as interest rates have fallen so much, most plans are not as well funded as the CFO would like. As a result, you're trying to figure out how to persuade the company into making more contributions and continue to derisk the portfolio. This is especially critical if the plan is hard frozen and essentially in runoff.
Trusted Insight: You joined Xerox a little less than two years before the financial crisis. Has it given you any insight into how to approach the current market environment?
Carol McFate: Not really. Once it became clear that we were likely in a “low-for-long” interest rate environment, given the degree of central bank involvement in financial markets, the focus on liabilities and hedging became much more important.
Before the U.S. election, interest rates kept dropping and risk assets soared to new levels, and conventional valuation metrics led to the view that markets were generally overvalued. Then, post-election, interest rates started to rise in anticipation of higher growth and inflation, while equities continued to rise. The conventional way of looking at valuation keeps changing, so being sensitive to your largest risk contributor, interest rates, is even more important.
It’s challenging because you can't look at any asset class through the lens of historical expectations. You have to be aware of the context in which you're living, and what that could mean for asset returns.
In many respects, this role has become more challenging. Yet it is more interesting at the same time. Given all the stimulation from the central banks, you know in the back of your mind that we are unlikely to see returns anywhere like what you saw before the crisis over a long-term horizon.
Trusted Insight: Pension funds must meet their near-term liability requirement, but at the same time maintain a long-term capital preservation perspective. How do you approach these uncertain times with those almost conflicting goals?
Carol McFate: Very carefully. It all depends on the “context” in which you are operating. What I mean by that is, how you invest is determined by your view of returns, the status of your plan (open, closed or frozen), the willingness of the plan sponsor to make additional contributions if markets disappoint, etc.
I am more interested in increasing voluntary contributions into the plan and derisking. Our plan is hard frozen, and we are on a path where, depending on the funding rules, we have a certain number of years to fully fund the plan. I have been focusing on convincing the company to make these voluntary contributions. We have a derisking glide path. When we hit triggers on the glide path, we will reduce return-seeking assets (primarily equities), and increase long-duration bonds to hedge the liability.
We have explored a number of innovative strategies to improve the returns from our return-seeking bucket, but it’s difficult. All pension plans CIOs are looking for something that will improve their overall returns and support their expected return.
Many CIOs are increasing allocations to less liquid investments. Due to the nature of our plan structure, we stopped making new allocations to anything illiquid a few years ago. Our investable universe is only liquid markets, increasing our challenge. The answer, although it's far from a perfect answer, is to make sure the return seeking allocation is as diversified as possible.
Trusted Insight: You were hired to reverse the outsourcing of the investment office. Tell me about that process of bringing the investment operations in house.
Carol McFate: Before we in-sourced the pension plan assets, we changed the duration of the fixed income portfolio from a core to long duration. The impact of this move was huge, as you might expect. Since then, we have increased our long duration fixed income allocation. Our hedge ratios are not as high as I might like, particularly considering what's happened to rates. On the return-seeking part of the portfolio, we have looked for other ideas to increase diversification and improve returns on a net risk-adjusted basis. Like all plan sponsor CIOs, we have found this task challenging.
Trusted Insight: Who do you consider your peers within the industry and what sets your strategy apart from theirs?
Carol McFate: I'm sure you've heard of the organization CIEBA (the Committee on Investment of Employee Benefit Assets). I'm a member of CIEBA and in its leadership. I have enormous respect for the members.
They were incredibly helpful in getting me grounded in this business. There was only one person on the Xerox team when I arrived, and her background, like mine, was not steeped in managing pension assets. Thanks to the guidance from my fellow CIEBA members, both of us have come a long way since then.
CIEBA members have been hugely helpful. The secret is we don't compete against each other. This is a rather competitive group of professionals. The race we’re trying to win, each of us, is against our own respective liability and trying to meet our organizational needs. We share ideas and commiserate about our challenges. It’s a great group—smart, professional and fun.
One of our colleagues, now retired, had a saying, which sums up how one should think about investing pension assets. I think it is spot on: "When you see one pension plan, you've seen one." Each plan is not like all the others; we're all different. You need to understand the context of your plan—financial wherewithal of the plan sponsor, the nature of the liabilities and the risk tolerance of the company.
Trusted Insight: In that vein, is there a fair amount of collaboration between other pension funds since you're all working toward a common goal?
Carol McFate: We share ideas, and CIEBA meets four times a year. When we meet, we talk about different ideas other CIOs are pursuing either in the DB or DC space. We educate each other, introducing new ideas and sharing the lessons learned from ideas that worked less well than expected. It's a phenomenal organization.
Trusted Insight: What trends, unique to corporate pension fund investment offices, are shaping how you invest?
Carol McFate: Again, it more relates to our unique circumstances, our context. To the extent that we receive voluntary contributions, we continue to derisk along our glide path. We are on a path to full funding and hibernation.
I believe we've scoured the return-seeking space in terms of what makes sense to us. We're always looking to see what's new, but we evaluate new ideas through a critical lens of “is it going to help me maintain the amount of return I'm hoping for from the return seeking bucket,” keeping in mind that net-of-fees performance is what really matters. Also we try to consider the impact on any new strategy of the next market shock, whatever it may be.
I wish I could say we had a secret sauce, but because of the massive amount of central bank stimulation and all the challenges around the world, there really isn't one. You build the best portfolio you can based on what you know and considering the constraints you have.
All corporate plan investment committees are ERISA fiduciaries. Whatever we do is through the lens of whatever is in the participants' best interest. I suspect if you talk to one of my peers who's been in this business a lot longer than I have, they will tell you that this business has become much more difficult. My attitude is: it is what it is.
Trusted Insight: Many investment professionals say they don't recognize the markets today.
Carol McFate: That’s true, but you have to deal with the hand you're dealt. It partially a result of the run up to the financial crisis and partly to the actions taken by central banks since then. If nothing else, this environment forces us to be more thoughtful and resilient. Even though that may not be easy for some, I personally feel it helps you grow as a professional.
Trusted Insight: What advice would you give to someone that's looking to enter this industry?
Carol McFate: Public company CFOs are unhappy about the huge increase in their unfunded pension liability. I suspect many of them would like us to discover a miracle to close the gap, but miracles are few and far between. It might make sense for each individual company, plan sponsor, to think about their tolerance to see their pension plan generate an outsized contribution to the company's overall risk -- whether it’s in terms of their risk to leverage or their risk to their sources and uses of cash -- and decide how they want to manage this going forward.
Today a lot of companies are doing lump-sum offers, reducing their overall liability. Some companies are executing partial buyouts through insurance companies. It's expensive with rates as low as they are. I think it's going to be a different answer for each company, and I would not be so bold as to suggest a solution for any one company or plan. It all comes back to the individual circumstances and risk tolerance.
Trusted Insight: You've painted a very challenging picture of the industry. What keeps you motivated?
Carol McFate: As an ERISA, you're charged with putting the participant’s interests first, doing the best job you can to secure their individual benefits. Those of us who manage assets for underfunded plans lobby the company for voluntary contributions to improve funded status and permit further derisking of the assets. If you can tell me how long it will be before interest rates normalize, then I can maybe give you a sense of what should happen next. Even with the increase in interest rates following the U.S. elections, I still believe we are in a “low-for-long” rate environment.
Trusted Insight: What have I not asked that I should know about you, Xerox or corporate pension plans in general?
Carol McFate: Defined benefit pensions were put in place as a tool to attract and retain talent. Many U.S. companies have had them historically. As competition has globalized, those U.S. companies started competing with overseas firms who may not have had this benefit, as the concept did not exist in those markets.
This benefit, while valuable to employees, has become very expensive for plan sponsors given the drop in interest rates and changing rules around DB plans.
For the CFO, it is a legacy cost of doing business, which they might not have if they were starting a company today. On the other hand, if you look at what happens in a world where employees only have a defined contribution plan, the participants have a burden to save for retirement, invest wisely and avoid overreacting to market gyrations; be able to figure how much they need to retire; and then spend down their accumulated DC funds to avoid running out of money before they die. That is a very difficult challenge for anyone, even a savvy investor.
This has been a fascinating time to be in this business. It has also been a frustrating time because you think you are taking an action that you believe is going to make a material difference, then because of factors beyond your control, it may not. But you do the proper analysis, you remain prudent regarding what you put before your committee, you execute carefully and you hope for the best.
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