LDI: Less Than Desirable Investing?
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Many chief investment officers (CIOs) of corporate pension funds with funded status less than 100% are being asked by senior management to de-risk their pension funds to prevent “large contribution” events. Sadly, many of these CIOs are being advised to either extend duration or implement equity put (or collar) strategies which lower the risk but also risk the future solvency of the fund.
Many funds were overfunded in the late 1990s because of the rally in equities. When that tech bubble burst, it led in large part to the growth of what we will call Liability Driven Investment (LDI) 1.0 Strategies, where many funds increased their duration to match liabilities in an attempt to lower asset-liability management (ALM) risks. This strategy was promoted aggressively by asset managers and derivatives overlay advisors. Many asset managers created duration pools and convinced clients to invest in these pools to extend their duration. This involved extending the asset portfolio’s duration to, say, 10 years, considerably longer than the typical 4-5 year duration of bond funds that pension funds invest in. Funds were told to invest 20-25% of their assets into the LDI pools to fully hedge the interest rate risk of their liability, leaving the fund with a significant portion of assets invested in a diversified return portfolio.
There were many problems with this approach: (a) It is easier to engage in an LDI strategy when a fund has more assets than liabilities; (b) it is a static approach; and (c) it feeds off the naïve assumption that funds must have allocations add up to 100% (driven by the assumption that all investments are made on cash instruments without using derivatives). The biggest problem with this approach is that extending the duration is a timing decision. Hence, the point of time at which a pension fund extends the duration (when rates are perceived to decline) and the point of time that it reduces the duration (when rates are expected to rise) can be a source of additional value while hedging interest rate risk. Lowering volatility of the asset-liability ratio does not fulfill the complete objective, as it focuses only on the risk and not on the return differential.
The next generation of strategies came post-2008, though staff at the World Bank had proposed it in 1999 and the ABN AMRO fund had employed it successfully through the crisis. It can be thought of as LDI 2.0: A Naïve De-Risking Approach. Some analysts show how funds can manage funded-status risk through a dynamic allocation to liabilities and risky assets based on the funded status. In effect, the portfolio is split into a Liability Hedging Portfolio (LHP), with explicit recognition of the liability profile mapped into liquid derivatives, and a Return Seeking Portfolio (RSP). A simple formula is set such that for an overfunded (underfunded) plan, as the funded status declines (improves), the allocation to the LHP is increased. The goal of this approach is to take risk off the table to preserve funding, if overfunded. On the flip side, and in today’s tough economic environment, underfunded plans are using this to protect the downside and de-risk the plan. This approach is best employed when the starting position is overfunded, because these programs are able to lock in funded status gains if they occur, but they struggle if the fund experiences a big drawdown as was the case this summer.
The failure of the previous approaches is that they are static at heart. The first step would be to ensure that liabilities are clearly mapped to a matching portfolio of swaps or futures (something most Dutch funds do). Second, one can implement the naïve solvency-based Dynamic De-Risking as it provides discipline, but this approach is insufficient. Ultimately, all investing is about market timing (whether for implementing the liability hedge or rebalancing) and smart investors have carved out a bucket in their portfolios where flexible beta management strategies are adopted. The goals of the absolute return programs that fit this bucket are to (a) earn a return greater than the liability over the target cycle without being anchored to a particular long-term allocation; (b) have a positive correlation to the liabilities; and (c) have a negative correlation to the asset portfolio (or equity risk). Such programs would be appealing in helping hedge against the negative asset-performance events in concert with the de-risking approach. The first goal is achieved by allowing allocations to be long and short in all asset class categories. This addresses the issue of ensuring that the return of assets must be greater than the return of liabilities. The second and third goals are essential to lowering ALM risks.
If pension funds do not get smart about managing assets relative to liabilities intelligently and succumb to the pressure from the C-suite to de-risk their portfolios, they may be entering a Faustian bargain that may leave them with higher future contributions and a good chance of having future crises as market volatility buffets their portfolios.
Dr. Arun Muralidhar is Chairman of Mcube Investment Technologies LLC (www.mcubeit.com), and CIO of AlphaEngine Global Investment Solutions (AEGIS). Arun is the author of A SMART Approach to Portfolio Management: An Innovative Paradigm for Managing Risk (Royal Fern Publishing LLC, 2011) and three other books. He has worked as a plan sponsor, asset manager, and supplier of investment and risk management technologies. He holds a Ph.D. in Managerial Economics from MIT.