Utter Confusion

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Glenview, Illinois is the headquarters of Mead Johnson Nutrition Co., which manufactures baby formula in the United States and around the world, with a particular focus in Latin America and Asia. As a manufacturer of children’s nutrition, the firm is noteworthy in a less obvious way, as it is in the midst of implementing a liability-driven investing (LDI) strategy—which, more generally, has taken hold as plans aim to lower their vulnerability to falling interest rates by hedging a greater portion of their liabilities’ interest-rate sensitivity. 

Nearly two years ago, Mead Johnson was spun off from Bristol-Myers Squibb. As their retirement plans were separated, Mead Johnson determined that the size of their plan, approximately $200 million in assets at the time, failed to justify having a fully resourced, internal pension management group. They instead outsourced much of the activity to Northern Trust. “Outsourcing that service to someone who has economies of scale allows us to take the limited resources we have and focus in other areas,” says Mead Johnson’s Vice President and Treasurer Kevin Wilson, who leads a team of seven people in managing all of the company’s global treasury functions, including oversight of the relationship with Northern Trust. “We’re fairly stretched as it is,” he says, echoing the sentiment of corporate pensions globally with limited resources and increasingly complex demands. “Our focus is on managing the funded status of the scheme, which is on the path to being fully frozen within a few years. As the funded position of the plan hits particular points, we move the emphasis of the assets more into a liability-hedging position rather than a return-seeking position,” Wilson says, outlining in simple terms the basic tenets of his LDI glide-path approach. 

This corporate pension in the suburban village of Glenview—with approximately $230 million in assets and $270 million in liabilities as of September 30, 2011—has succeeded in getting through what many consider the most difficult phase of implementing an LDI strategy, namely, getting everyone to think in terms of an asset-liability perspective, with the realization that the fund is not just a pool of money but a pool with a well-defined purpose. As opposed to thinking purely in terms of assets and return, a sponsor pursuing LDI must think in terms of liabilities—a shift in thinking that many investors view as an ever-present hurdle. “In pursuing LDI, we began asking ourselves: What do my liabilities look like? If I have all the money I need to satisfy obligations, how would I invest it to be safest?” Wilson says. Consultants note that other questions that corporate schemes pursing the approach need to wrap their heads around include: What kind of liability hedge do I need to implement with my current level of assets? If I don’t have all of the money I need right now, what do I need to do to earn my way out of a deficit? Of the risk-taking I’m intentionally engaging in, how do I structure my entire portfolio, both the return seeking and liability-hedging components, to get the most bang for the buck? Would an unexpected contribution cause a great deal of stress?

This stark shift in mindset reaffirms the fact that LDI is not simply an add-on, but an integral part of a corporate pension’s investment strategy—a theme championed by Jay Vivian, the former Managing Director of IBM Retirement Funds. Wilson describes the shift toward an LDI way of thinking as an internal educational process. Those who implement LDI in some sense embrace an element of humility that the future is uncertain. The rationale behind those who have implemented the strategy is that even the wisest and most successful investors cannot be 100% certain about how every investment decision will fare. LDI, then, is in a way a barrier against the unknowns of the market—a safety net to guard against extreme market swings with the basic premise of LDI being to understand and more effectively manage the risk in investment portfolios versus the liabilities they support. Risk, therefore, should not be perceived with fear and apprehension. Instead, proponents of LDI assert that risk should be taken with precise intention. 

That intention, as fully embraced by Mead Johnson’s pension fund, reflects its decision to shift its asset allocation to 60% in liability-hedging fixed income and 40% in return-seeking equities and alternatives when it reached a funded status of 90%. The scheme’s glide-path strategy, implemented by Northern Trust in January 2011, incorporates funded-status triggers to de-risk over time, thereby increasing the allocation to liability-hedging assets or long bonds. Mead Johnson’s pursuit of LDI also partly explains the plan’s success in weathering the market: Based on reports and anecdotal evidence released on the health of pension funds recently, Mead Johnson’s plan performed relatively well in August, with the funded ratio falling 1.5% during the month versus a roughly 4% to 6% drop for a broader universe of pension plans.

Pension plans should have a clearly articulated goal of improving funding statuses by X% over X time period, consultants advocating LDI say. Outlining the steps of implementing the strategy, which typically spans a period of three months, consultants say the first step is assessing plan details, determining whether the plan is frozen, “soft”-frozen, or active, with frozen plans being the easiest to de-risk as a result of certain benefits. A plan sponsor must then assess its funded status, with underfunded plans being the most expensive to close out. Finally, LDI involves analyzing the fund’s asset position, as high allocations to risky assets must be transitioned in order to close-out or de-risk. Like Mead Johnson’s corporate scheme, the transition toward a more LDI-heavy strategy is also facilitated by the use of trigger points. These trigger points can define proactively, and in advance, the best time to make asset allocation changes and when to make rebalancing decisions, serving as strategic markers of where a plan sponsor should be if they have no emotion about what the market is doing. 

General Motors—perhaps the symbol of the deteriorating affect of pension debts on corporate profits—was not created as a pension plan, yet its pension grew to dwarf its core business, and like many plan sponsors, the scheme has become a legacy problem. 

The spark driving the popularity of LDI within the corporate pension fund universe comes from heightened regulation that demands greater solvency and higher funding ratios, along with the general longing to allow sponsors to focus increasingly on their core business as opposed to, like General Motors, being distracted by their pension—often a pestering side problem. In 2006, the Pension Protection Act (PPA), which came into effect in 2008, provided the first set of rules forcing American sponsors to systematically contribute to their pension to carry them to full funding. (To read more on pension regulatory pushes worldwide, see page 8.) Between 2003 and 2007, the funded status of plans in the US ballooned from 77% to 96%—a remarkable increase at first glance. But according to a UBS research paper by Francois Pellerin, a heightened level of contributions made by plan sponsors largely fueled the increase—highlighting a prevalent misperception among sponsors that a pure increase in equities got them out of their rut. “In analyzing the liabilities of 500 publically traded companies with the highest pension exposure, I found that on average, the pension plan was 46% of the size of the company,” Pellerin notes, adding that “LDI has flourished to control volatility so that plan sponsors can worry about what they’re good at—whether its building cars, making widgets, or whatnot.” 

The longing among corporate funds to dynamically de-risk out of equities is clear, with the numbers speaking for themselves. In April, findings from Casey Quirk & Associates and eVestment Alliance’s annual survey of investment consultants in the US and Canada revealed that alternatives, emerging markets, and LDI strategies will dominate search activity this year. The study demonstrated that more than one-third of investment consultants surveyed anticipated a boost in LDI mandates in 2011, with three-fifths of consultants expecting moderate or strong bond search activity this year. The greater attention to LDI corresponds with previous research from MetLife that showed underfunded liabilities are a top concern among US corporate plan sponsors.

Vendors, pension heads, and consultants largely agree that while an LDI philosophy—or an approach focused on risk management—can be embraced at any funding level, implementation may be dictated by sponsor considerations, current funded status, and the market environment, with certain key funding thresholds specified by law delaying the implementation of the long-term asset allocation. “At 70% funded, plans tend to have a meaningful allocation to return seeking assets,” says John McCareins, Northern Trust’s senior program manager for Mead Johnson’s plan. “As funded status improves above 70%, a discussion on introducing or increasing liability-hedging assets generally becomes more relevant.” 

“LDI is a risk-management exercise,” notes Scott McDermott, the Goldman Sachs Asset Management (GSAM) LDI guru, describing the context of the current challenging climate of low interest rates. The question for plan sponsors is usually not whether to pursue LDI, he says, but where they stand on the degree of implementation. “LDI involves articulating a strategy,” asserts McDermott, who focuses on pension management and strategy within GSAM’s Global Portfolio Solutions team. “There’s no doubt LDI has created a bigger demand for high-quality, long-maturity fixed income. The big question is: Is the supply adequate?” So far, however, he asserts that the supply has been sufficient to meet the needs of sponsors pursuing an LDI-heavy strategy. 

For all the talk about the timing of LDI implementation, one issue is often forgotten: There are few other options for pension plans looking to de-risk. While lower rates may create implementation issues—as schemes will phase out of risky assets more gradually as opposed to all at once—LDI implementation for a large majority of pension plans is simply a matter of timing.

So, despite all the current problems with interest rates, schemes need to anticipate future obligations and start planning—with LDI being one strategy to do so more effectively, sources advise. In reaction to Operation Twist—the US Federal Reserve’s strategy of selling shorter-term debt and using the proceeds to purchase longer-term bonds—plan sponsors and investment consultants say the Fed probably did more harm than good in this little slice of global markets—likely increasing corporate underfunding by about $50 billion to $60 billion by decreasing discount rates. “By keeping long yields lower than they otherwise would be may be helpful overall to the economy, but not to corporate pension plans,” says Tony Gould, managing director and head of JP Morgan Asset Management’s New York/London/Asia Fixed-Income product team. “Some plans have been waiting for a mix of higher equities and bond yields, and improved funded status, to implement LDI strategies. The Federal Reserve capping long yields, coupled with a deteriorating global economic outlook for 2012, suggests the risks in delaying LDI implementation are significant.” Still, investment consultants say that the persistent question from clients center around the concern that low interest rates will make it difficult to implement LDI. However, when aiming to extend duration, the common advice is: Do it now, don’t wait. When extending duration, consultants often say incorporating a blend of Treasurys and corporates is the most appropriate way to proceed. 

The essential step in extending duration, of course, is to buy bonds with longer maturity. If buying longer bonds is not an option due to scarcity, then the common advice is to incorporate derivatives. While most fixed-income managers have the permission to use derivatives, most won’t use them systemically, still uncomfortable with the idea of leverage and uneasy about benchmarking the result, as derivatives entail some restraints and are more complex. Furthermore, the evolution into an LDI strategy involves continually thinking of a glide path—or the changing mix of a portfolio as the funded status improves, not taking risk when you don’t have to. It involves continually thinking in terms of what your liabilities look like, questioning the balance between risky investments compared to their safer counterparts, and thinking about how the balance should evolve over time as circumstances change.

Despite the environmental roadblocks schemes face in implementing the strategy, one of the greatest obstacles is often perceived as being a change in behavior and attitude—a change that is often much slower and more difficult to catalyze than any alterations to an actual investment portfolio. “It’s an interesting and challenging time for plan sponsors,” asserts James Moore, Managing Director of Product Management at PIMCO. “I’m curious to see what happens between now and year end. After the roller-coaster ride of the financial crisis in 2008, people have been getting motion sickness from such turbulent market swings. Even though it may not be the best time to go into LDI right now, I don’t think plans will be able to stomach such high volatility for long.”

Mike Thomas, CIO and head of consulting at Russell Investments’ Americas Institutional business, offers one memorable analogy on the use of LDI: You can hear a train coming and you don’t know whether it’s coming on the track you are standing on or not. Proponents of LDI say that while some clients can handle being hit, their advice is usually to get out of the way. Mead Johnson’s scheme has taken that approach. As corporate pensions are increasingly blindsided with an unanticipated volatility in funded status and as their objective of focusing on future liabilities becomes more concrete, getting out of the way may be their saving grace.