November 1, 2012 (PLANSPONSOR.com) – Misconceptions about liability-driven investing (LDI) prevent many investors from implementing this strategy.
According to a white paper by Standish Mellon Asset Management Company LLC, the fixed income specialist for BNY Mellon, LDI strategies mitigate interest rate risk and it may not be advisable for pension funds to wait for rates to rise before implementing the strategy.
The paper addresses 10 common questions regarding pensions and LDI, including whether pensions should implement LDI in a low interest rate environment. Standish believes there are sensible ways to incorporate this interest rate uncertainty into LDI approaches, such as to establish a glide path in which interest rate risk is diminished over time. Regarding whether a plan that implements LDI should invest 100% of assets in fixed income, Standish said plan assets can be categorized as either return-seeking or hedging. The amount allocated to fixed income should be based on plan status, plan type, funded status, interest rate outlook, liability duration, plan objectives and the sponsor’s ability and willingness to take risk.
The paper also favored pensions selecting active management for long duration bonds despite the lower fees associated with an index fund. It said there are sufficient inefficiencies in the corporate bond market to warrant an active approach to selecting the appropriate long-duration exposure. Standish also addressed appropriate benchmarks for a plan’s fixed-income allocation in an LDI strategy, whether the pension should invest only in high-quality bonds to best match the discount curves, how it analyzes a plan’s liabilities, how a glide path is structured, and how it evaluates the level of interest rates and forecasts future direction.
Standish contends that derivatives can play an important role in the management of an LDI strategy from both a strategic and tactical perspective, and outlines different options. Furthermore, the paper addresses the minimum level of tracking error that can be achieved in an LDI strategy.
The white paper, “The Case for LDI in Any Interest Rate Environment: Clarifying LDI Misconceptions,” is available here.