Around the World with LDI
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“The world is a book, and those who do not travel read only one page.”
Saint Augustine’s words may not have been inspired by liability-driven investing (LDI), but they do fit the theme quite nicely.
Institutional investors all around the globe have the same goal: to make the assets they have stretch long enough and far enough to cover their liabilities, or the payments they have agreed to make.
From California to Cairo to Canberra, the Gordian Knot all pension funds must unpick is how to match up these two amounts—and for each pot of money, there is a singularly distinct plan on how to do it.
Over the next few pages, aiCIO will take you on a world tour of pension funds that have each trodden their own LDI path, and we will show you the wide variety of options the strategy can entail.
Along the way, we will visit some of the first adopters of LDI, who realized straight after the tech-stock meltdown that just relying on equity returns would not help them reach their goals.
Another plan we will drop in on was forced by regulation to get a tighter hold on its portfolio matching—despite being relatively well-funded.
We will also encounter a corporate pension that realized the hard impact it would have on its sponsoring company if its liabilities were not tamed—and took advantage of the economic downturn to put its house in order.
Our last stop will be with a plan that is growing by billions each year, and that has figured out a way it can keep meeting its burgeoning liabilities without over-reliance on any one supplier—or bringing its LDI capability in-house.
To be able to admire the diversity on offer around the world, the best way to travel is with an open mind, so aiCIO invites to fasten your seatbelts, sit back, relax, and be our guest as we take you around the world with LDI…
Canada / Healthcare of Ontario Pension Plan (HOOPP) / LDI Provider: In-House / Fund Size: C$50 Billion / Funding Level: 119%
“In the 1990s, we had a surplus, but after the tech collapse, our liabilities went up as our assets went down.”
In 2003, HOOPP CEO Jim Keohane had an epiphany. “We had recovered somewhat off the lows, and our actuaries said we had a 50% chance of becoming fully funded again. They also said that there was a 25% chance that we would be significantly underfunded. That sounded like a trade I would never make,” he says. “We had to start managing risk, rather than passively accepting its consequences. We took a pragmatic approach to identify the major risks that could negatively impact our ability to pay pensions and ensure they didn’t happen. They were a decline in long-term interest rates, an unexpected rise in inflation, and equity market risk.”
Keohane realized that a lot of HOOPP’s risk came from mismatched assets and liabilities—and really started to consider LDI. “We certainly look different than other pension schemes,” he says. “A lot of funds talked about pursuing LDI after the tech meltdown, but we were one of the very few who actually did it. LDI resumed as a hot topic after the credit crisis, but once markets improved, talk died down, and again very few funds actually implemented LDI strategies.”
To Keohane, Einstein’s famous quote typified many of his peers: The definition of insanity is doing the same thing over and over and expecting a different result. “We decided to shift from peer comparisons and traditional benchmarking. You may beat the FTSE 100, but if the market goes down, the organization is not successful, because you have less money to pay pensions.”
There is one paradox common to all Canadian plans, however. “In one sense, we have a very long-term time horizon. We might be collecting contributions from a 25-year-old nurse and still be paying their benefits at 95-years-old. On the other hand, we have a regulatory compulsion for being fully funded, the measurement for which comes every three years.”
HOOPP uses a lot of derivatives. “We use pretty much everything,” says Keohane. “We used to have a foreign content restriction, so we used derivatives to gain our overseas exposures and diversify a concentrated position in Canadian securities. Using derivatives lowered our risks; we were able to separate alpha from beta and create building blocks to get synthetic exposures—this helped us match our assets with liabilities.”
Today, the fund’s liability-matching portfolio contains most of its physical assets. These help hedge out inflation risk, wage inflation, and cost-of-living adjustments. This portfolio returns around 4%, but HOOPP needs 6% to make the scheme function—so it has a return-seeking portfolio, too. This is largely derivatives-based and includes equity index futures and swaps, credit overlays, and volatility overlays. “You need scale to run this type of thing internally,” says Keohane. “You need some non-traditional skill sets that include Treasury operations, derivatives, and collateral management.”
You need investment, too. “We had a five-year strategic plan running from 2005. It took two years of planning and three years to build the system to support the new portfolio structure.”
The Netherlands / Pensioenfonds Openbare Bibliotheken* / LDI Provider: F&C Investments / Fund Size: €1.5 Billion / Funding Level: 117%
“Before the crisis, our solvency level was 160%. After the crisis hit, it fell to 90%.”
This meant Eldert Grootendorst, chairman of the Librarians’ Pension Fund, and his colleagues had to act fast. The Dutch National Bank requires the country’s pensions to be 105% funded. If they are not, they have to come up with a recovery plan that can take no longer than five years to complete.
However, this sudden pressure was not the fund’s first shock. Regulation introduced in 2007 meant interest-rate risk on pension fund assets had become visible—and therefore something to be controlled—like never before.
“We found three companies with different strategies; F&C’s methodology was solvency-based and suited what we needed,” says Grootendorst. “We were looking for a solution that meant we would never end up in a worse position.”
The pension embarked on a mission to curb downside risk without affecting potential upside. They did this with derivatives—a complex system that Grootendorst was able to explain to board members simply. “We told the board—and our members—that the strategy would prevent us falling back in solvency terms. It would also prevent us getting to 150% and above, but we don’t need to be there,” he says.
The pension improved in stages, and after each improvement the worst-case scenario became easier to bear. “We went from 90% being the worst, to 95%, to 100%, to 105%, which is the regulatory minimum. We now have a 7% chance of falling below that. Two years ago, it was a 25% chance of it happening.”
The pension opted for swaptions and equity collars because of the cost and in order to benefit from rising markets, Grootendorst explains. “Swaps decline in value in a rising market, whilst receiver swaptions are expensive upfront, so we asked F&C to find a way for us to have the same outcome but for a lower price. We now have a maximum of a 140% funding level to aim at. We have the assurance that we can pay members’ benefits and have a little left for potential indexation.”
The fund also has triggers in place, but rather than some automatic mechanism locking in at a certain pre-ordained rate, these triggers spur debate on what to do next. “This week, the S&P has risen to one of our trigger points, so I’m in London to talk with our manager about our possible moves,” Grootendorst says. “We have a strategy that allows us to think and discuss what to do when we hit a major event.”
The strategy has worked—and quickly. Pensioenfonds Openbare Bibliotheken is now 117% funded. It is expanding, too. New government-run library staff, who would ordinarily enter mega-fund ABP, are set to become members of the pension.
But it’s not all good news, Grootendorst warns: “Things are not certain. There may be new regulation in the Netherlands at the end of the year, and it could shake up how we approach our fund. If or when it happens, we may have to reassess what we do. We may stick with this strategy—or need a new one.”
United States / Joy Global / LDI Provider: SEI / Fund Size: $1.03 Billion / Funding Level: 97%
“I want to fund these unfunded liabilities once, not many times.”
Former Joy Global Chief Financial Officer Mike Olsen’s words are the backbone of the mining firm’s LDI strategy.
“We were very heavily equity-biased—which is typical of many US plans—and had maintained the belief that equity returns would fund our unfunded liabilities,” says Barbara Bolens, treasurer at the company. “But the CFO, working with SEI, decided that by using this method there were too many items beyond our control.”
Bolens joined two years ago when the LDI program was already in full swing. Olsen had been thinking about these unfunded liabilities before the financial crisis and had implemented the first stage of the plan.
It involved constructing a bond portfolio that closely matched the fund’s liabilities—rather than an arbitrary corporate bond benchmark—and hiking up sponsor contributions. And there was a twist.
“We took a multi-pronged approach,” explains Bolens. “In 2010, we changed our fixed-income mandate from long-duration to be benchmarked against our liabilities—this meant our actuaries had to work very closely with the fund managers, much more closely than they had before.”
Extra contributions went into the LDI portion of the fund—where the matching bond portfolio was—and benefits were paid out of a separate part so the LDI strategy could be left alone to get to work.
Joy Global’s pension is now 97% funded, which means peace of mind for the company.
“Our pension is highly sponsor-dependent,” Bolens says. “At 18%, the size of the US pension plan compared to the company’s market capitalisation is large. We wanted to have greater certainty about market impacts on our pension—and on cash flow.”
The cyclical nature of the mining industry means there are always peaks and troughs to navigate—but these can be turned to an advantage. “When a business is growing, as was the case before 2008, it consumes cash,” says Bolens. “Putting it in a pension is not seen as a good use of cash at that point. When this growth slows, putting cash into the pension makes more sense.”
So where’s the talk of repo, swaptions, and derivatives?
“LDI doesn’t need to be that complicated,” says Bolens. “When you go into many of these derivative products, you’re taking on leverage—you’re taking a bet. If you have a sound strategy and a clear view, you don’t need to do that. We were pretty clear from the start that we wanted things to be very transparent. We don’t have a dedicated person to oversee such complicated and costly structures in-house, which is what would be needed.”
The process has gone so well that Joy Global is working with SEI to implement an LDI strategy for its UK pension fund.
“The biggest hurdle we faced was the company agreeing to the additional contributions and giving up a reliance on equity returns,” Bolens concludes. “It may not be so easy for a company that is strapped for cash, but for us, it was a better strategy.”
United Kingdom / Pension Protection Fund (PPF) / LDI Providers: VARIOUS / Fund Size: £22 Billion / Funding Level: 110%
“Our approach is ‘True LDI’. Our investment target is set as beating our liabilities.”
The UK’s lifeboat for bankrupt company pensions has pretty much succeeded, according to Executive Director of Financial Risk Martin Clarke. The Pension Protection Fund only failed to do the above in the 2008/2009 financial year.
“The liability-matching component of the fund is the largest, and underpins our strategy,” Clarke says. “Over the last three years, we have beaten our liability benchmark by a total of 10% (last year by nearly 5%), so we are in a very strong position.”
However, the PPF has an uncommon problem in the pension world: It keeps growing. The hedging program, which uses swaps and repo, is the largest in the UK, Clarke thinks.
This might have presented the PPF with a headache—but the team turned it into an opportunity. “Historically, we have carried out LDI by outsourcing to one provider: Insight Investment,” Clarke says. “We realized there were dependency issues. We have no issue or concerns about Insight itself, however.”
The PPF decided on “2xLDI” to take more strategic control.
“It was tricky to tie up the two managers, as we had to reconcile different methods and pricing models. Essentially, we were working with two different versions of the truth,” he explains. “This way, we have more control of benchmark-setting. Insight Investment and now Legal & General Investment Management (LGIM) have to work with us using our own standards.”
The PPF had to review its contracts with Insight and alter what LGIM would normally propose. “Of course, investment managers would not vote for this out of choice—but there are more benefits than disadvantages to doing it.”
But if the PPF was not concerned about Insight’s strength, why did it need two LDI managers?
“It’s not like choosing an equities manager, where each has a different style and view of finding returns in public markets—all LDI managers do the same thing,” admits Clarke. “But in our case, one is active and one is passive. We don’t have an over-reliance on either—it’s not unknown for an entire team to depart to another company.”
It took the PPF 12 months to put the structure in place. Now, it can flex between the two providers. “We also now independently manage our collateral. It is done centrally to ensure efficient use of collateral in a two-manager model. We have more control over the process and can be assured of best execution.”
Is the next step to bring LDI in-house? “Not necessarily,” says Clarke, “but we are building up our expertise and getting closer to being able to carry things out ourselves. We have brought real-asset investment capability in-house already.”
The PPF is on a journey, Clarke says. “That’s not to say we are going to commit to more LDI managers, but other pension funds have seen what we are doing and are looking carefully. If they have high dependency on one manager, they may decide to follow our lead.”