Timing Your LDI
Institutional investors who may be worried about writing bigger checks than they expected for their pension contributions may want to start thinking about liability-driven investing (LDI) now, before any nasty surprises happen. A sudden change in interest rates, a miscalculation of longevity risks, or other unforeseen factors might call them to task if contributions rise more than anticipated.
“If you didn’t have that base covered, then your board or oversight committee says, ‘What went wrong here?’” said Stephen Horan, managing director, credentialing, at the CFA Institute.
To mitigate the risk of an unpleasant surprise, many plan sponsors embrace LDI, which attempts to match a pension plan’s investments with its liabilities—driving investments based on the sponsor’s cash flow needs to pay current and future liabilities. LDI must take into account both sides of the plan sponsor’s balance sheet—a different approach from traditional 60-40 equity-fixed income benchmark investing, which focuses almost exclusively on the assets side of the sponsor’s balance sheet.
LDI is growing in popularity with plan sponsors. In Vanguard’s October 2016 Survey of Defined Benefit Plan Sponsors, for example, 80% of respondents said they were using an LDI strategy, versus 68% in 2012.
BlackRock, one of the world’s largest LDI providers, sees growing interest, with approximately 25% of its business tethered to highly customized portfolios managed relative to pension plan liabilities, with many others more informally tied to liabilities, according to Matt Nili, head of US LDI at BlackRock.
Cognizance of Liabilities
Even if a plan isn’t ready to embrace a full LDI strategy because it can’t perfectly match liabilities and cash flow, every defined benefit plan should be “liability cognizant,” said Karl Dasher, chief executive officer of Schroders North America and co-head, fixed-income.
There are two big forces driving increased interest in LDI, according to Brett Dutton, lead investment actuary in Vanguard Institutional Advisory Services. Dutton said they are seeing companies increasing abilities to make consistent pension plan contributions, along with an increased acceptance among them that the current low-interest-rate environment could stay for now.
Immediately after the 2008 financial crisis, pension plan contributions took a backseat to keeping the business solvent, he said. Today’s corporate balance sheets are stronger, giving plan sponsors the opportunity to consider additional pension plan contributions to improve funding status, rather than rely on portfolio returns from riskier assets, he added.
“I’m seeing clients in a healthier position in terms of their business overall, and they’re more willing to make cash contributions to their pension plans,” Dutton said. “I think they’ve gotten through the financial crisis, they’ve benefited from more optimism in the economy, and that’s given them more flexibility with the organization’s balance sheet to do as they please.”
Plan sponsors should think about LDI strategies in a total portfolio context, according to Nili. BlackRock looks at factors such as funded status, the magnitude and composition of return-seeking assets, as well as end goals. When he works with sponsors, Nili says, two of the questions they ask are: ‘What return should we target as our funded status improves?’ and ‘How would BlackRock compose the growth part of the plan’s portfolio when considering the liability?’
While plans differ, usually institutional investors need to alter their legacy investment portfolio to extend the duration of the fixed-income assets to a long-duration benchmark strategy, Nili said.
But extending duration can make some plan sponsors uneasy, especially if they believe the Federal Reserve is now normalizing monetary policy and interest rates will rise to their historical norms, according to David Wilson, head of the institutional solutions group at Nuveen Asset Management. He said a plan sponsor’s view on future interest rates is the biggest impediment to taking this first step in using an LDI strategy. Wilson said he believes the Fed won’t be able to completely unwind its quantitative easing program anytime soon.
Since the 1980s, interest rates have trended lower, and with the Fed’s quantitative easing, some fixed-income investors held short-duration bonds expecting rates would eventually rise. Dutton noted that in the past several years, plans that invested in intermediate- or short-duration bonds based on fears of rising interest rates lost ground significantly to those who invested in long-duration bonds.
Various approaches
There’s no one size fits all approach to LDI, and many plans will implement LDI in stages. “We’re thinking about investment strategy from a funded-status perspective, every plan should start at that point. It doesn’t mean that every plan has to de-risk or go to a lower-risk strategy,” Dutton said.
Open plans, or those that have a long-term, multi-decade time horizon to meet their liabilities, may need a higher-risk investment strategy that uses growth assets like equities to take advantage of having a longer time to invest, Dutton said.
For plans that are trying to be liability-cognizant because they can’t do true liability matching, it may make sense to keep growth assets but include downside-risk protection, Dasher said. In this case, some risk-management options include collaring strategies to hedge the equity side of the portfolio, he said.
“One of the things that [has] been popular over the years [has] been managed-volatility equity strategies. That fits into a liability-cognizant strategy, even though it’s not liability matching, per se,” Dasher said.
Some open plans, or those with long-time horizons, may have liabilities that go out 30, 40, 50 years. There aren’t enough physical bonds with matching durations, but plans shouldn’t worry about those far-off payments when it comes to matching duration to liabilities, Dasher said. Rather, it’s about matching fixed-income duration to the liability, and a typical pension plan has about a 14-year liability duration.
“A key aspect of de-risking is you’re not matching the cash flow of the liabilities; you’re matching the duration to the liability,” Wilson said.
De-risking becomes a bigger part of the LDI strategy when the plan is being closed/frozen or already in that state, Dutton and Wilson agreed. There are a couple of common paths, Wilson said. One way is to gradually de-risk by using the funded ratio as the trigger. As the funded ratio improves, the LDI manager allocates more of the portfolio to long-duration fixed-income to more precisely match the plan’s liabilities.
“The early stage de-risking is just extending duration. The late-stage de-risking is to precisely match the liability. It’s able to be done gradually by most plans,” he said.
Type of LDI Strategies Respondents Said They Were Employing
Why Many Pension Plans Haven’t Gained Funding Since 2009
Cumulative returns for the period ending June 30, 2017
A second way to execute a de-risking strategy is over time, especially if a plan sponsor will commit cash to make the plan fully funded, he said. That’s where each year the sponsor looks at the size of the plan’s unfunded liability and makes contributions that will lead to a fully funded status at the end of a specified period of time, typically over several years.
Wilson explained how he is working with Essentia Health’s $225 million pension plan to ensure full funding within 10 years (and not simply waiting for interest rates to rise). “They deemed LDI as the most effective de-risking tool available to corporate plan sponsors, and the time-based component alleviated the need to wait for rates to rise,” he said.
After conducting a comprehensive risk analysis for the plan, Nuveen partnered with Essentia Health’s chief investment officer and their investment consultant to develop a time-based glidepath and ongoing risk framework.
Wilson said the strategy created a structural discipline regarding investment risk and contributions, and maximizes the probability of meeting their funded ratio target and risk goals.
“We are in year two of a 10-year strategy. We actively monitor the plan and progress along the glide path. We also deliver a customized client dashboard to the client on a quarterly basis in addition to managing the bond investments,” he said.
If the plan sponsor of a closed plan will commit corporate cash to the pension fund over a period of time, it may not need to take much investment risk at all, Dutton observed.
“In my mind that makes the case for a lower-risk investment strategy stronger,” he said.
But there’s a trade-off for plan sponsors wanting to put more money into their plans versus reinvestment in the company itself, Dasher said, and this needs serious contemplation. “[This is] probably the most important thing for any company to think about—the trade-off between the capital that they can invest in their business versus adding more certainly to the pension-fund line item,” he said.
Art by Rose Wong
Hedging Levels
How much a pension plan hedges its funding status risk with its investments will depend on a plan sponsor’s risk tolerance and time horizon, Dutton said. When determining an investment strategy, there’s a split in the portfolio between return-seeking assets (equities or alternative assets,) and the liability-hedging side, (bonds meant to offset the interest-rate risk in the liability.)
A sponsor with a high degree of risk tolerance may use 60% or 70% return-seeking assets, but that figure could fall to as little as 20% or 10%, and perhaps not include any equities in the portfolio, if the sponsor has a very short time horizon, low risk tolerance, or a well-funded plan, he said.
Nili believes that, at a minimum, most plans should be at least 50% interest-rate hedged and there’s a strong case for a higher percentage hedge for more fully-funded plans.
“As a plan progresses down the glide path, those ratios should approach 100%,” he said.
Plans should look to long government or corporate credit when matching liabilities, Nili said. One way plans may increase duration without changing their portfolio significantly is to incorporate Treasury STRIPS, which is becoming more popular for plans on a glide path.
Wilson said a mix of Treasury and corporate bonds can be good vehicles for plans looking to de-risk and boost duration. The Nuveen Pension Investment Indexes uses a mix of intermediate and long-duration corporate bonds, along with the ultra-long Treasury STRIPS, which have a duration of about 26 years.
“You match the liability as best you can with the corporate bonds indexes, and you use the STRIPS for the necessary duration,” he said.