Liability-driven investing (LDI) strategies have been used by defined benefit (DB) plans for decades, but gained steam with the passage of the Pension Protection Act (PPA) of 2006, which increased penalties for underfunded pensions, and the financial crisis of 2008, which reduced returns on assets dramatically.
With increased volatility of the markets and low interest rates increasing liabilities and the price of purchasing bonds, the question is, is LDI still effective? Yes, say experts, who believe LDI is still a viable approach for derisking DB plans.
According to October Three Consulting’s October Pension Finance Update, October was a down month for investors, but pension sponsors were able to tread water, as the impact of higher interest rates on pension liabilities offset asset losses. Both model pension plans it tracks saw basically flat results on the month. Through October, Plan A is down nearly 5% and the more conservative Plan B is down nearly 1% on the year.
Stocks lost ground in October: A diversified stock portfolio lost more than 2% during October but remains up more than 4% on the year. Interest rates saw their biggest jump in the year in October, producing losses of 1% to 2% on bond portfolios in October. For the year, bonds remain up 7% to 8%, with longer-duration bonds enjoying the best results.
Interest rates jumped more than 0.2% during October, reducing pension liabilities by 1% to 2%. Rates have moved higher since hitting all-time lows in July, but pension liabilities remain 8% to 12% higher than at the end of 2015, with long-duration plans seeing the biggest increases.NEXT: Considering the duration of bonds
Owais Rana, managing director at Conning, a global asset management firm with $120 billion under management that advises corporate pension funds, insurers, and other institutional investors, who runs the investment solutions business that covers insurance, pensions and LDI, and is based 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 DB plans are predominantly invested in equity, funding has been very volatile.
“The challenge is not that LDI hasn’t worked, the challenge is DB plan sponsors want to derisk 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.”
Rana says those pension plans that were very-well funded and adopted a highly engineered, customized LDI program years ago are in a much better spot today.
Dan Westerheide, senior vice president and co-head of the Data Asset Liability and Risk Management Group at Segal Rogerscasey in Boston, 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. “While most clients have not been 100% hedged by long-duration bonds, they have most of their portfolios in long-duration bonds.”
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. How much duration to use to match liabilities revolves around interest rate levels, but the vast majority of Segal Rogerscasey clients haven’t looked at the low-yield environment today to justify reducing hedge ratios, according to Westerheide.
“Rates could go up from here, but the approach of most of our clients is that, through analysis, they have determined what hedge ratio should be,” he says. “In a disciplined manner they are getting there, and not trying to time the markets.”NEXT: Using triggers
Rana says those pensions that are underfunded and haven’t adopted a full LDI strategy need to think about the ultimate objective if they were fully funded. What investment strategy would they implement if fully funded? With that target in sight, they should build a derisking glide path that will take any unnecessary risk off table, he says. This may include equity investments in some cases, but they should adopt investments that will match liabilities and use triggers.
In an LDI strategy, many DB plan sponsors uses funding level triggers—meaning when the plan reaches a certain funding level, the allocation to equity and bonds will change. Rana says, DB plan 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. “For example, if the 30-year Treasury bond rate reaches 3.5%, a plan sponsor may decide to use that asset in its LDI strategy.”
Having triggers in place, DB plan investment committees will have committed to LDI strategies with two objectives—they will use assets that match liabilities but not locking in investments today, and as they become better funded, they are going to derisk, Rana says.
With the volatility of the equity markets and the move in bond interest rates, Westerheide says Segal Rogerscasey hasn’t seen a lot of churning with glide paths. “Modest triggers are being hit and adjustments are being made, but by and large the strong equity volatility and move in rates more hasn’t resulted in a whipsaw of glide paths,” he says.
He adds that clients are not abandoning their LDI framework even through what the markets are doing.
Rana adds that, “We’ve seen time after time that having views on the markets can work sometimes but most of the time it hasn’t worked that well, so DB plan sponsors need to take the human qualitative judgement out of the administration of pension plans. Having a derisking path in place fulfills what’s important in the market perspective as well as the risk perspective,” he says. “What we advocate for is keeping the human judgement element out of the equation. For example, if rates go up, some committee member is likely to want to wait and see, but when the opposite happens, it hurts pensions.”