(June 4, 2014) — Improving funding ratios and rising interest rates may prove liability-driven investing (LDI) an inefficient derisking strategy for corporate defined benefit (DB) plans, according to research.
“While this LDI strategy yielded benefits in neutral market environments (when the probability of rates rising and falling was equal) and during periods of equity market instability (when a flight to quality favored bonds), we believe neither of these scenarios is consistent with current market conditions,” private equity firm KKR said.
Citing “typical” portfolio data from aiCIO’s November LDI survey, KKR factored in interest rates trending upwards by 50 basis points per year in the next few years. The firm said the drop in the value of bond portfolios is projected to offset any decreases in liabilities accomplished by traditional LDI strategies.
A better alternative, the report argued, is absolute return strategies, largely due to their low volatility, low beta, and marginal correlation to interest rate changes. KKR observed two separate simulated absolute return derisking strategies and found they were both likely to increase funding ratios and even increase risk-adjusted returns, according to Sharpe ratio measurements.
“Derisking with absolute return tends to be more effective in protecting and improving funding ratio than LDI,” the report said. “Greater allocations to low beta absolute return strategies effectively reduce the sensitivity of the funding ratio to equity dislocations.”
One approach—decreasing allocations to the return-seeking portfolio by replacing 10% of equity-like assets with 10% of low-volatility absolute return—resulted in an 80% probability of achieving higher funding ratios than through LDI for a typical 60/40 portfolio, KKR found. It also bumped the portfolio’s Sharpe ratio from 0.41 to 0.45.
A more aggressive strategy of lowering the fixed income allocation to 30% from 40% and adding 10% of absolute return, upping the return-seeking portfolio to 70%, was even more effective in improving funding ratios.
“Since absolute return has similar risk and higher return than fixed income (albeit lower return than equity), [this strategy] leads to an even higher median funding ratio than [the first strategy],” the report said.
Despite absolute return’s apparent efficacy, KKR warned investors of a certain degree of downside risk of weak equity markets causing declining funding ratios.
However, the benefits of absolute return outweigh the harm, the firm said, since the advantages of LDI materialize only if rates drop significantly and equity performances wane—a situation that is unlikely in today’s rate environment.
“Pension sponsors who are focused on the liability effect may be tempted to tilt toward an LDI strategy,” the report said. “However, with rising rates, such a strategy will be effective only under extreme conditions. The cost will be reduced performance under most conditions.”
Related Content: Funding Gains, PBGC Hikes Push Corporate Pensions to De-Risk, 2013 Liability-Driven Investing Survey