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How to Not Use Liability-Driven Investing: The UPS Way

From aiCIO magazine's November issue: Sage Um reports on CIO Brian Pellegrino's choice not to implement an LDI program.

To view this article in digital magazine format, click here.

Brian Pellegrino, CIO of one of the last open defined benefit funds in America, isn’t afraid to reiterate UPS’s decision to forego liability-driven investing (LDI): “We do not feel that LDI is an appropriate strategy at this time.” A bold move, as LDI has now infiltrated most corporate pension plans’ investment strategies to the extent that it’s almost second nature.

But Pellegrino may be smart to play the black sheep among a herd of corporate pensions. UPS is one of the healthiest funds above $20 billion. It boasts an almost 91% funding ratio with $27 billion in assets to its name, while liabilities total only 30% of the corporation’s market capitalization. Pellegrino and his team have high expectations—8.75% returns over a three- to five-year horizon—but they easily surpassed the estimate in 2011 with gains of 9.4% amid a flat market.

“Some characteristics drive us to build a materially different portfolio than most corporate plans,” the CIO explains. Rather than one specific strategy or another, Pellegrino bows to the need to allocate assets and construct a portfolio in the best interests of UPS and its employees.

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The Atlanta-based courier service has the right—and rare—factors in place to excuse itself from liability matching, according to consultants and managers familiar with the terrain. “There’s only a minority of funds that can afford to do it,” says Scott McDermott, managing director of the global portfolio solutions group at Goldman Sachs Asset Management. Those plans that “are still open and have a financially strong corporate sponsor, for whom the plan liability is not material to the parent company’s financials, tend to be risk takers.”

So how did UPS acquire the ability to take more risks than other corporate pensions? The story begins with the parcel workers. A particularly young population of participants and fewer retirees put liability duration at somewhere between 17 and 18 years, with benefit payouts peaking after 2030. The firm also profits from a smaller annual benefit-payout ratio relative to assets than is typical, shelling out just a bit more than 3% compared with its peers’ average ratio of 9%.

“The long horizon allows us to gear more toward generating sufficient returns to meet future liabilities, rather than protecting assets to pay our current obligations,” Pellegrino says. “We’re somewhat uncertain of our future liabilities as our employees are still accruing benefits.”

UPS’s focus isn’t to put out fires, but to ensure the plan can weather all storms to deliver payouts on time, every time. Pellegrino is confident in the financials of his fund: They have enough capital to cushion and manage a potential hiccup, he contends. This is largely due to its promising obligations-to-market capitalization ratio. “Our unfunded liability relative to market cap is small. Since we moved to mark-to-market, we have become less concerned about short-term variability.”

Other corporate plans aren’t so stable or lucky. General Motors initiated a $26 billion pension-risk transfer deal with Prudential last year, surely due to its large liabilities compared with market capitalization and the potentially devastating impact of pension shortfalls on corporate financials.

“It’s a very individual decision,” says Joe Nankof, partner at Rocaton Investment Advisors, on whether or not to implement an LDI program. For some, “there are situations where it makes less sense to de-risk and more sense to continue to take risk for the purpose of generating returns.”

That’s exactly what UPS strives to do. Less concerned with matching liabilities to assets, UPS allocates far less to fixed income than other corporate plans—27% versus an average of 40%—and predominantly to long-duration treasury and corporate bonds. But return-seeking assets also have a place in the fund’s unconventional fixed-income portfolio, including high-yield bank loans, global bonds, and emerging market debt. With the space freed up by its modest bond holdings, UPS allocates an extra 6% to 8% to alternatives and public equities, with an overweight to US equity.

Pellegrino says the plan’s public equity portfolio is likewise not your average corporate pension stock bucket. “We believe the traditional market-cap benchmarks are flawed for various reasons, so we’ve created our own custom indexes that provide specific exposures, such as global consumer staples, managed or minimum volatility, and other risk-based metrics,” he says. “We’ve also added highly concentrated benchmark-agnostic managers who can focus on absolute, rather than relative, performance.”

The pension plan originally operated under a traditional investment structure—allocating assets, selecting managers, then assigning them a benchmark to outperform. It wasn’t until UPS was hit hard by the financial crisis that Pellegrino and his investment team thought to revamp the system. “2008 was extremely painful,” he admits. “We found that managers who invested aggressively or took excessive risk got hurt, and that had a huge impact on our portfolio.”

The revamping process began with building out the investment team. After some staff turnover in 2010, Pellegrino successfully grew his staff from three to 15, all focusing on a group trust structure under a single-employer Taft-Hartley plan. By now, the team has invested in secondary and co-investing opportunities in real estate and private equity, as well as liquid alternatives. “We’re looking for investments where we can understand what is driving returns, and with a runoff somewhere between three and seven years,” Pellegrino explains. “We are comfortable locking up assets for three to five years, especially if we know with some certainty what the outcome of that investment looks like.”

These strategies are paying off. According to company data, UPS had well exceeded 100% of its annual 8.75% return objective by the end of the third quarter of 2012, gaining more than $2.2 billion.

So what’s a CIO to do when he’s done more than he planned to do? “Once we cross the 100% threshold, we’re not as concerned about generating more [returns] as we are about protecting what we’ve earned for the year,” Pellegrino says. But funded status isn’t a priority for UPS, he continues. Governmental Accounting Standards Board statements put UPS past full funding, and mark-to-market accounting no longer considers shortfalls and adjustments based on pension performance in the operating profits and loss statements.

This kind of viewpoint provokes concern in some. “There’s a myth out there that if you’re a long-term investor, you can count on actually getting the high expected return assumption—but economists universally point out that this myth is not true,” says Barton Waring, an economist and the former CIO of investment strategy and policy at Barclays Global Investors. “It doesn’t matter how long your horizon is. You still need to hedge your liability in order to protect the safety of the plan’s benefits and to protect shareholders from large, unpleasant surprises.”

Others assert that abstaining from LDI may not be a reckless choice. “The decision to not pursue LDI doesn’t necessarily mean you’re [failing to] look at pension risk in a sophisticated risk-factor framework,” Rocaton’s Nankof says. “It’s about being deliberate about not matching assets and liabilities and taking that risk.”

Pellegrino understands this idea: “We realize that there will be years we do not achieve our goal of 8.75%. If you pay attention to the value of the assets and the investment opportunity in essence, you will capture the LDI or hedging component naturally.”

By the end of 2012, UPS’s hedging ratio was hovering above 20%—just enough to protect its assets and provide a level of flexibility and freedom to pursue riskier investments. “When you think of LDI, you think of portfolios’ hedge ratios and specific glide paths on when to increase those ratios,” Pellegrino says. “We give ourselves a tremendous amount of flexibility to move within asset classes and across the portfolio. We also put a lot of effort into evaluating the risk inherent in any investment, always focusing on finding the best risk-adjusted returns.”

If UPS continues to deliver investment returns as reliably as it does parcels, then flexibility isn’t a liability for Pellegrino and his team.  

Home > News > Newsmakers > Challenging Liability-Matching (With New Approaches)
Newsmakers

Challenging Liability-Matching (With New Approaches)

From aiCIO magazine's November issue: Innovations in LDI tools, products, and ideology. Elizabeth Pfeuti reports.

To view this article in digital magazine format, click here.   

On a spinning globe, you have to keep moving just to stand still; so it is in the world of liability-driven investing (LDI).

Since LDI’s first iteration of using government bonds already held in institutional portfolios, the industry has developed by using diverse asset classes and derivatives to offer a large range of options for hedging out pension funds’ unrewarded risks.

It has not been a smooth ride. In recent years, investors and their service partners have had to cope with stubbornly low interest rates, seemingly un-curbable liabilities, and an uncertain outlook. These factors have combined to start investors thinking—or in some cases removing—options they had relied on in LDI and coming up with new ways of carrying out the process.

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The different maturity levels of LDI around the globe have allowed those a little late to the party to learn from the trials and errors carried out by early adopters.

So what is in store for investors?

Consultants are busy creating and refining new ideas for the LDI sector. Some of them are still on the drawing board. Some of them may remain there. Some are proactive, some are reactive—but change is happening.

Firstly, the triggers that many European pension funds put in place after interest rates were reduced to historic lows have had a makeover. Many of these trigger points were arguably meant to have been hit by now. Interest rates were not meant to stay this low for this long.

“There has been a general trend away from target triggers—interest rates at 5% or 1% real yield, for example—and more of a move towards affordability or funding as being the key,” says Kenny Nicoll, director in manager research at consultants Redington. “The logic is that if your return-seeking assets double in value, then why wait for interest rates’ yields to rise another 10 basis points? If you can lock in, you should do so and recognize that portfolio performance is more important than the straight rates level chosen.”

For many pensions, this new set of triggers makes sense. Most of the largest LDI markets have been told that their nominal interest rates are not going to go up for many months, so with the recent market rallies increasing portfolio valuations, this seems like a natural development.

Interestingly, the US—a market acknowledged as being slightly behind its European cousins on the LDI-adoption curve—has already cleared this hurdle.

Just 5% of funds employ triggers that are linked to interest rates, according to Chris Levell, partner at NEPC. The rest use funding ratios as the prompt.

There are further echoes of the financial crisis causing headaches across the wider system, and investors are indirectly affected.

Repo has been European pension funds’ hedging instrument of choice in recent years, but as central banks are asking the sell-side providers to reduce their balance sheets, they are becoming less keen to participate in the trade.

“The leverage ratio, which limits the amount of leverage in a bank’s balance sheet, will potentially limit the amount of repo business—particularly in low-margin business like gilt repo—that they are willing to do,” says Nicoll.

Every bank is different, but regulations are uniformly strict, so Basel III and various international post-crisis legislations are likely to have an impact across all the bulge-bracket institutions that offer repo.

“We expect to see banks wanting to offer repo lines with greater optionality and certainty attached—and margin,” Nicoll says. Higher margin for the banks means higher costs for pension fund hedges, and there could be an additional problem: They might have to take a step back in time. “Running a repo desk is dependent on volume,” says James Fermont, partner at LCP. “When some banks retreat from the market, pension funds will have to revert to swaps—something many trustees may not feel comfortable with.”

Pension funds may face internal issues due to post-crisis regulation, according to Mark Davies, investment director at PSolve Asset Solutions. “Central clearing regulations in Europe may push pensions away from using derivatives,” he says. “They may decide that the price they have to pay is just too much for taking off the risk it removes. An extreme case might be to switch over portfolios to use physical assets for LDI and employ synthetics in actual investment portfolios due to increased costs.”

Innovation—or enforced change—does not have to come in the form of tools, gadgets, or products created by asset managers and investment banks, however. Ideology is also shifting. David Rae, head of LDI Solutions for EMEA at Russell Investments, believes people thinking about how to actively manage LDI assets and integrate them into an overall strategy will change the landscape.

“It’s time investors were compensated for what they are holding in a proper fashion, rather than measuring it against an arbitrary benchmark,” says Rae. “There is a natural nervousness to enter a deal where you won’t know if it has been successful for several years, but if investors understand the rationale behind it, they can witness it coming through.”

PSolve’s Davies agrees that most major changes to LDI are likely to come through implementation. “It’s a way off, but it will happen: Providers will be able to use straight-through processing to access member-specific data to design portfolios,” he says. “Providers are technically infinitely better than they were five years ago; they have more accurate data and can use this to eliminate the gaps.”

In the US, where advisers have been watching European struggles and successes with interest, pensions are continuing to embrace the glide-path technique of LDI. “Glide paths have been a way for decision-makers to agree. They can say, ‘Well, we’re not fully funded now, but we will be in X years,’” says Levell at NEPC. “In the UK, investors didn’t have enough duration in their bond portfolios, so they used derivatives—we are going straight to this second step. Real assets are rarely used as any kind of hedge for LDI in the US due to the governance structure. Many corporate sponsors are not keen on illiquid assets as they may want to get rid of the plan, and illiquidity makes it harder to do so.”

Rae at Russell says an evolution from general, non-specific LDI portfolios to much more tailored hedging strategies is underway. “Schemes in the US have taken the first steps of recognizing the true nature of their liabilities and extending duration using relatively simple techniques. Much of current work with clients has been on building a more detailed and customised strategy that is a better representation of the liability. The development of indices and products has assisted with this next stage.”

Not all US pensions have bought into the LDI story, however, mainly due to one large risk-management option.

“Pensions are generally eschewing LDI for risk transfer,” says Jeff Leonard, managing director at Wilshire Associates. “Many are getting their house in order to transfer the risk to an annuity provider rather than look at an asset allocation that would make sense for them long-term.”

All agree that pension funds have become keener to monitor their matching and growth portfolios, with increasingly frequent checks—often daily—becoming common. This may be, Leonard suggests, because they want to know how ready the fund would be at any given moment to buyout—should the occasion arise.

Regardless of geography and chosen path to a desired outcome, Davies at PSolve says there is one issue that needs to evolve. No matter how complex and sophisticated solutions may become, one of the biggest changes has to be a deeper delve into risk management. “Only one-third of all UK pensions hedge all their liabilities, according to KPMG. We are worrying about the nitty gritty when a bigger issue is still getting pensions to engage.”

Fermont at LCP agrees that focusing on potential new bells and whistles means drawing attention away from more central issues: “New approaches? Pensions first need to make sure that the LDI approaches they already have in place are going to withstand the rigours of new regulations—which were made with the best of intentions.” 

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