LDI in 2011: A Faustian Bargain? | Chief Investment Officer

From aiCIO Magazine's Summer Issue: CEOs are demanding that their pension funds be de-risked to avoid large contribution surprises, yet de-risking means lowering equity exposure when underfunded pensions need equity-like returns.

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Chief executive officers are demanding that their pension funds be de-risked to avoid large contribution surprises, but de-risking fundamentally means the substitution of equities for bonds—exactly when underfunded pension plans need equity-like returns to get back to full funding. Is this a Faustian bargain?

No, say some of the leading liability-driven investment (LDI) providers. “It is a question of contribution policy, and I wouldn’t call it Faustian,” says Scott McDermott, Managing Director in the Global Portfolio Solutions Group of Goldman Sachs Asset Management. “Some plan sponsors may reasonably choose to de-risk a pension plan to obtain greater certainty of future contribution requirements.” This might be a more apt choice for certain industries working under a Pension Protection Act environment, McDermott believes, particularly “plan sponsors in highly cyclical industries where poor pension investment results, leading to unexpected demands for greater contributions, are likely to occur just when the plan sponsor’s core business might be experiencing a cyclical trough and the need for conserving corporate resources is highest.”

Kim Lisella of Cutwater Asset Management agrees, noting that de-risking over a set time frame allows plan sponsors to avoid the Faustian quandary to a degree. “By employing a disciplined approach to de-risking, such as setting funded status milestones, plans remove the temptation to time unpredictable markets, such as equities or interest rates. Since the milestone plan will be executed over time, plan sponsors can allocate to fixed-income in different market environments, allowing a systematic reduction of funded status and contribution volatility.”

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However, one veteran of LDI implementation is more cautious in his assessment. “One caveat for plan sponsors exploring LDI along these lines is to make absolutely sure it’s clear what trade-off you’re considering,” says Jay Vivian, former chief of the IBM retirement system. “To me, trading off the risk of contribution surprises with the risk of lower expected long-term return to the pension plan looks like a legitimate fiduciary trade-off. However, trading off the risk of contribution surprises with the risk of lower expected long-term return to the plan sponsor (and thus the plan sponsor’s P&L) is arguably not a legitimate fiduciary trade-off.” It is important to consider the funding issue from a fiduciarily correct way, Vivian claims. “The distinction may seem like a small one, but, to me, the former looks legitimate, smart, and appropriate, albeit difficult. The latter, it could be argued, could be considered to be a trade-off with one side not properly considering ‘the sole benefit of the beneficiaries’.”

Vivian asks an interesting question: If a CEO is pressuring his CIO to de-risk the plan for the sake of the company—and not solely for the sake of the plan beneficiaries—is there a risk of breaching a fiduciary duty? Time, experience—and a good ERISA lawyer, probably—will ultimately tell, but such suggestions surely provide something for the intelligent CIO to consider before he bows to management pressure and de-risks. A deal with the devil is for life, after all. —Kip McDaniel

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From aiCIO Magazine's Summer Issue: While some say China's economy may be robust enough for the country to become its own asset class, many consultants and other asset managers disagree.

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With the Chinese economy’s seemingly inexhaustible rise from agrarian to world-dominating, recent comments from an Allianz Global Investors subunit CEO boldly proclaiming that China would soon comprise its own distinct asset class may not be shocking. It’s just wrong, think many consultants and other asset managers.

“I think you’ll see Chinese stand-alone strategies,” says Chris Levell of Massachusetts-based consultancy NEPC. “However, are you going to see institutional investors say ‘Here’s my Chinese assumption, here’s my rest-of-Asia assumption’; I think that’s some years off. The specter of what they’re doing with capital control, what they’re doing with the Renminbi peg, all the top-down things they still can do, I think limit the opportunity to say ‘Wow, this is just a single place we should be.”

Some, by way of example, are less diplomatic. “Is Canada an asset class? No,” says James Rickards, Senior Managing Director at New York-based Tangent Capital Partners. “Canada has characteristics of the U. S.,” and is thus not a distinct asset class largely uncorrelated with other equities, he believes. “Developed economies are an asset class, emerging markets are an asset class—but China should not be treated as an asset class.”

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Asset classes, at their most basic, can be defined by two factors: similar risk characteristics within the group (i.e., infrastructure investments all involve some form of physical plant), and a distinct correlation apart from other asset classes. China, it can be argued, has neither. The variability of investments in China range from the fabulous to the fraudulent, Rickards points out, making it difficult to place a China play in one bucket. As NEPC’s Levell says, even a much-vaunted China is tied closely to other markets, both near and far. “Although you’ve seen decoupling, if Asia does poorly, China will do poorly,” he says, adding “I like to have fewer asset classes. I think you invest in equities, and you might have tilts to different regions, you might choose a manager structure that has specialists—but you’re taking equity risk,” and not a region-specific risk.

China: It may be good investing but, according to many, it is not—and never will be—an asset class. —Paula Vasan

To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742