With increased volatility of the markets, and low interest rates increasing liabilities and the price of purchasing bonds, the question is, are liability de-risking strategies still effective?
Owais Rana, managing director at Conning, a global asset management firm headquartered in New York City, notes that long-term low interest rates have resulted in increasing liability values, and the market has been quite choppy. So if defined benefit (DB) plans are predominantly invested in equity, funding has been volatile.
“The challenge is not that LDI hasn’t worked—the challenge is DB plan sponsors want to de-risk more, but they don’t want to buy bonds at high prices,” he says. “If pensions were 95% to 100% funded, we would probably see a lot more buying of long-duration bonds.”
Dan Westerheide, senior vice president and co-head of the data asset liability and risk management group at Segal Rogerscasey, says one of the components in adopting an effective LDI strategy is how to position the duration of bonds.
“For our broad set of clients, a component of asset allocation is long-duration bonds to match liability duration,” he says.
With many plan sponsors in an underfunded position, there is ongoing discussion about the right hedge ratio to match liabilities, Westerheide adds. “Even though there has been a recovery in equities, interest rates have continued to come down, increasing liabilities. So DB plan sponsors continue to work away at underfunding,” he says.
Rana says those pensions that are underfunded and have not adopted a full LDI strategy need to think about the ultimate objective if they were fully funded. With that target in sight, they should build a de-risking glide path that will take any unnecessary risk off the table, he says. This may include equity investments in some cases, but the plans should adopt investments that will match liabilities and use triggers.
In an LDI strategy, many defined benefit plan sponsors use funding-level triggers—meaning when the plan reaches a certain funding level, the allocation to equities and bonds will change. Rana says, these sponsors could also have a trigger that is based on long-term interest-rate levels. “If buying at current levels is too expensive, sponsors can set a target price for when they should buy,” he says.
Having triggers in place, a DB plan investment committee will have committed to an LDI strategy with two objectives: 1) to use assets that match liabilities but not lock in investments today, and 2) to de-risk the plan as it becomes better funded, Rana says.
“We’ve seen time after time that having views on the markets can work sometimes,” Rana adds, “but most of the time it hasn’t worked that well. So DB plan sponsors need to take the human qualitative judgment out of the administration of pension plans. Having a de-risking path in place fulfills what’s important in the market perspective as well as the risk perspective.”