The Liability-Driven Investing Issue… For Now

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In the financial industry, the farther one moves from Wall Street, the nicer the people. Asset managers are nicer than investment bankers. Asset owners are nicer than asset managers. Even within the catchall of asset owners, there is a niceness hierarchy—and corporate pension CIOs may be the nicest of them all.

That said, they still bargain hard. When I asked Robin Diamonte, CIO of the United Technologies pension and current chair of the Committee on Investment of Employee Benefit Assets (CIEBA), if she could have the group take our annual Risk Parity Investment Survey, I should have expected a catch.

“Yes,” she told me at the time. “But if we do, we want to see the results first—and you should come to CIEBA to do it.”

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Of course, this wasn’t much of a catch. Many a liability-driven investment (LDI) manager would give their first-born to be in a room with the Who’s Who of American corporate investing, which CIEBA annual meetings are. Journalists and conference organizers (I’m both) feel much the same way. Thus, in late October, I happily ventured to Washington to brief the esteemed group on our risk parity survey results.

What I saw there: Two very convincing emerging-market focused hedge fund managers totally disagreeing with each other; a debate between NEPC and Mercer on the merits of risk parity within an asset-allocation strategy; and ex-IBM pension manager Jay Vivian barking like a dog (“The key is to know that dogs bark while breathing in.”).

What they saw from me: A 15-minute sneak-peek viewing of our risk parity survey, complete with what I believe is the first-ever client rating of managers in this space.

I really should have been presenting on our Liability-Driven Investing Survey, which is featured in this issue. Risk parity is currently sexier than LDI, but the latter is clearly a topic du jour, chaque jour for corporate pensions in America (and often abroad).

And yet even that wouldn’t have quite sufficed. Because of the way products are sold to pension funds, and who is making decisions within the pension corporate infrastructure, the industry often speaks of products in silos. As one industry insider told me: “Each participant in the supply chain (asset manager, consultant, CIO, investor, insurer, CFO) has a different goal—respectively, growing assets under management, growing billable revenue, beating benchmarks, reducing volatility and risk, increasing assets under annuity, and maximizing pension income.” If every interested party had one goal—a funded plan that was not large relative to the sponsor—then “every tool can benefit the participant,” he continued. By every tool, he meant not just LDI, but pension risk transfer (PRT), investment outsourcing, and more.

That is the fundamental flaw with this issue, which we refer to internally and externally as our “LDI Issue”. It’s a limiting moniker because corporate plans aren’t thinking like that, just as they don’t think of PRT and outsourcing as discrete trends. They’re all tools used to execute the same action: de-risking.

So this, in a sense, is our last LDI-labeled issue. Henceforth, call it the “De-Risking Issue”—not because LDI’s time has passed, but because its time has truly come.

Kip McDaniel, Editor-in-Chief

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With liability-driven investing (LDI) gaining traction on both sides of the Atlantic, one has to ponder: Where have all those funds in LDI structures been moved from?

The obvious answer is equities. As pension schemes seek to diversify risk, most have divested some of their equity allocation and increased the proportion of liability-matching components—largely fixed-income instruments. But there are other strategies that lose out. David Rae, head of LDI solutions EMEA at Russell Investments, says there’s a strong argument for why domestic corporate bonds could be dropped by European funds.

“Corporate bonds are inferior to an LDI strategy when it comes to hedging the liabilities, and inferior to a more diverse portfolio when it comes to adding value,” says Rae. “You can get far more interest-rate exposure to hedge your liabilities with an LDI strategy, and a more efficient return-seeking portfolio by allocating to global credit, high yield, emerging market debt, mortgage bonds, and active absolute-return bond strategies.”

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Traditional property could also be due for a chop, according to Redington. Dan Mikulskis, co-head of ALM and investment strategy, said: “A pension fund that has adopted LDI is more likely to focus on assets that can be used for both return generation and liability matching, like illiquid credit assets such as infrastructure debt, and away from more traditional property and private equity. Schemes will have a limited liquidity budget and will focus on using this most effectively.”

Others argue that the sophisticated nature of LDI in Europe, where the use of derivatives and leverage is commonplace, means investors are not forced to sell anything in order to lower their risk levels. “There are limits, but it’s quite commonplace to have a strategy that is, say, 75% hedged to interest rates and inflation, while simultaneously being 50% to 60% invested in growth assets,” notes John Belgrove, senior partner at Aon Hewitt. “There doesn’t have to be a ‘loser’.”

In the US, Erik Knutzen, CIO of NEPC, says anything in the growth bucket can suffer if LDI wins. “That could include credit strategies, risk parity, hedge funds, and an array of private market strategies,” he notes.

Indeed, risk-parity strategies that don’t use leverage or derivatives could become particular casualties, especially given the threat of rate rises in the near future. The $25.1 billion Iowa Public Employees’ Retirement System has just rejected a move to a risk-parity whole-portfolio approach for exactly that reason.

Belgrove believes this decision may require a second look, however. For that decision to pay off, rates would have to rise by more than the market expects, he argues, as bond prices—the typical loser from rising rates—are derived from market expectations of the yield curve. And as many an LDI investor knows all too well, the market already expects rates to rise quite a lot.