David Zielinski of State Street Global Advisors considers the mistaken beliefs about liability driven investment (LDI) that exist in both Europe and the US
Since the passing of the Pension Protection Act and FASB Statement No. 158 two years ago, liability driven investing (“LDI”) has become one of the hottest topics of discussion for the US defined benefit marketplace. Despite the growing implementation of LDI solutions, a significant portion of the US market still needs education on the mechanics of a liability-based investment policy. For many pension schemes, a lack of education and technical understanding of LDI is a major obstruction to adopting it.
In this article we will address, in ascending order, the top 10 misconceptions of LDI.
#10: LDI is a product or fixed income strategy
A common misconception is that LDI is a product or a standalone fixed income strategy, and that plan sponsors can simply dedicate a portion of their plan to LDI. However, LDI is more than just a single strategy. More importantly, it is defined as a risk framework that focuses on improving the risk efficiency of the total plan by aligning the exposures of the assets to those of the liabilities. In most instances, LDI implementations do not consist solely of fixed income securities but rather they include diversified growth-focused exposure that seeks to add excess return over the liabilities.
#9: ‘Liability driven investing’ and ‘immunisation’ are one and the same
In the late 1970s and early 1980s, immunisation strategies were widely discussed because high interest rates during this period made that type of pension investment policy attractive. At present, immunisation can be thought of as one form of implementation under an LDI risk framework, and an extreme one for that matter.
#8: LDI removes all risk from the plan
LDI does not remove all risks from a plan. These risks include interest rate, equity and actuarial risks. The tools used to hedge interest rate risk, including government and corporate bonds, futures and/or swaps, will determine the amount of interest rate risk removed, or hedged. For those plans that implement a hedging and growth portfolio to enhance returns, equity risk can be the largest remaining risk in their investment policy. The third risk arises from the differential between actual cash payments to retirees and those projected by the actuary. Factors that could change the actual benefits payments include how long retirees live (longevity risk), at what age they retire, and how many working employees leave the organisation before retirement.
#7: It is impossible to implement an LDI strategy without using derivatives and/or leverage
The true success of a plan is its ability to meet all future benefit payments. Plans that are prohibited from using derivatives can still reduce elements of interest rate and equity risks. Interest rate mismatch between asset and liabilities can be reduced by extending the duration of a plan’s existing fixed income allocation and/or increasing their fixed income allocation all together. Most fixed income benchmark providers offer long physical bond indices that can be managed against either actively or passively.
#6: Liabilities are long-term in nature and equities will outperform in the long run
Traditional total rate of return investing for defined benefit plans consists of a core bond allocation, which is combined with an allocation to domestic and international equities, typically ranging from 60% to 80%. The goal is to maximise the return on assets by having exposure to those asset classes with higher expected returns and capturing the equity risk premium. In the new pension reporting regime, plan sponsors can no longer focus solely on the long term, as short-term reporting requirements can have a significant impact on the plan and the sponsoring entity.
#5: Derivatives are too risky
Plan sponsors actively question whether the potential benefits of using derivatives outweigh the potential risks of taking on counterparty exposure.
The clear benefit of an overlay hedging strategy is that it provides asset duration exposure in a capital efficient manner, which means plans can help reduce interest rate risks without disrupting their existing asset allocations. Second, a closer look at counterparty exposure reveals that strong counterparty risk controls and collateral management can help reduce counterparty risk to a point that is essentially less than taking on corporate bond exposure.
#4: Any fixed income asset manager can develop an LDI strategy
Plan sponsors’ first step in implementing an LDI investment option has tended to be extending duration in their existing bond portfolios. While the majority for core bond managers will have the capability to manage either active or passive long duration strategies, they may not have the necessary governance structure to manage LDI strategies which evolve over time.
A strong governance structure and diverse product base is necessary to help ensure that the appropriate LDI product option is implemented initially and that the LDI provider has the capability to adjust portfolio investments as the plan’s objectives and risk tolerances change.
#3: Adding long duration exposure to a portfolio just increases its volatility
Long duration bonds are inherently more volatile than shorter duration bonds given their higher sensitivity to changes in interest rates. The misconception with this statement lies in the context with which it is taken. Under a pure asset-only framework, this statement is true. However, under an LDI risk framework, it is important to remember that the goal is to reduce funding ratio volatility rather than focusing solely on the volatility of the assets. Since plan liabilities generally range from 12 to 20 years, a long duration asset portfolio will correlate more closely with the liabilities than a short duration asset.
#2: Changing a plan’s existing allocation and investing under an LDI framework is too costly
“Too costly” commonly refers to the decline in expected return as a plan reduces exposure to growth securities and increases fixed income exposure. While lowering expected return has the potential to increase future contributions to the plan, it remains as just one factor that influences the final investment policy under an LDI risk framework.
Key to constructing LDI solutions is finding a balance between reducing funding ratio volatility, hedging interest rate exposure, and meeting excess return objectives.
LDI is about constructing more efficient portfolios. For instance, by adding an interest rate swap overlay, a plan can reduce risk as measured against the liability profile. By not disrupting the existing asset allocation, we create a more efficient portfolio without a reduction in overall expected return.
#1: LDI shouldn’t be imple-mented when rates are so low
Questions regarding interest rates being too low should begin with two key risk factors for the plan sponsor—current funded status and current interest rate hedge ratio.
Regardless of the level of interest rates, interest rate mis-match should be viewed as an active element within the investment policy. For plans that are fully funded, the appetite to take on interest rate risk should be low. Gains due to taking active interest rate positions come with a greater downside utility than upside, as in the case of a fully funded plan falling into an under-funded status when interest rates fall.
While interest in liability driven investing remains hot, there are still a number of misconceptions in the marketplace on what LDI actually entails. SSgA’s top 10 misconceptions are just a few of our clients’ and prospects’ most frequently asked or debated topics. LDI may or may not be appropriate for every plan. However, every plan sponsor should fully understand the concept and factors which determine the applicability of LDI and the various forms of implementation it can take. Only after a full review and complete understanding of these factors takes place, can a plan sponsor make an informed decision on whether or not it applies to the plan.
