From aiCIO's November Issue: Delving into a question that tantalizes both supporters and opponents of liability-driven investing (LDI).
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Is liability-driven investing dead? It is a question that tantalizes both supporters, who perhaps secretly fear that it is, and opponents, who possibly suspect that the answer is no.
The above paragraph, by almost any measure, is plagiarism. In 1966, Time magazine asked “Is God Dead? It is a question that tantalizes both believers, who perhaps secretly fear that he is, and atheists, who possible suspect that the answer is no.” While the iconic cover of that Easter-week magazine was remembered long after the article it represented was forgotten, its thesis was this: While 97% of Americans believed in a God, their relationship with Him (or Her) was changing. It wasn’t so much that God was dead, but that older ways of relating to Him were. It spoke to a post-war moral crisis, the discombobulating chaos of the 1960s, and perhaps some overly serious inquiry about that which is inherently uncertain.
Just as 97% of Americans claimed belief in God when Time asked that question, an overwhelming percentage of pension funds and the people who service them currently believe in the holiness of liability-driven investing—LDI, in industry parlance. Yet like God, those who tout LDI perhaps secretly doubt its veracity, and those who reject it possibly doubt its fallibility.
So now is the right time to ask a similar question. Is LDI dead?
To answer the question of death, the issue of birth must be addressed. While Martin Leibowitz—he of immunization fame—is rightly credited with bringing LDI into the post-Employee Retirement Income Security Act (ERISA) pension era, the foundation of his work on “cash matching” portfolios lay before, during, and just after the Second World War.
The War era, it seems, sparked a small revolution in fixed-income investing theory. The idea of duration for fixed-income securities was first espoused in a 1938 study; a 1942 paper pointed out that by matching the duration of assets and liabilities, interest rates would have a somewhat or entirely neutral effect on portfolios; independent academics quickly came up with similar theories, suggesting a fragmented group of men (and yes, all men at that point) working on the idiosyncratic problems of portfolio matching.
This fragmentation ended with Frank Redington. Unlike the other authors of fixed-income duration work at the time, Redington was not an academic. Instead, he was an in-house actuary for the United Kingdom insurance company Prudential. In 1952, he penned “Review of the Principles of Life-Office Valuations,” a strikingly boring title for what would turn out to be a seminal document in immunization theory.
Redington’s prose (unlike his titling ability) is vibrant in a way that only a non-academic could achieve. “The original purpose of this paper— undertaken at request but not unwillingly— was to review the principles and practice of life-office valuations in the light of modern conditions,” he wrote. “It was difficult, however, to deal satisfactorily with the principles of valuation in vacuo without reference to more fundamental principles. As a consequence the paper has become more ambitious in its scope than originally intended— and has threatened to run away with itself. The reader will perhaps be less disappointed if he is warned in advance that he is to be taken on a ramble through the actuarial countryside and that any interest lies in the journey rather than the destination.”
This ramble, it became clear, was more a dive into an entirely new way of thinking about bond portfolios. The crux of it was this: “The word ‘matching’ implies the distribution of assets to make them as far as possible equally as vulnerable as the liabilities to those influences which affect both. This implies the distribution of the term of the assets, in relation to the term of the liabilities, in such a way as to reduce the possibility of loss arising from a change in interest rates.” Put in context, this was the first direct discussion of how institutional portfolios could protect themselves against interest-rate risk.