LDI May Still Leave Risk on the Table

August 19, 2014 (PLANSPONSOR.com) – Liability-driven investing (LDI) helps a defined benefit (DB) plan meets its liabilities, but liability benchmarking adds precision.

LDI is a good start, but it may not be enough to reduce exposure in a DB plan, says Kim Lisella, senior client portfolio manager and assistant head of distribution at Legal and General Investment Management America (LGIMA). “We’ve been looking at how assets performed against the liabilities, not their market benchmarks,” Lisella tells PLANSPONSOR. It is not a brand new approach, she says, and LGIMA has been using this strategy in custom portfolios. Until recently, it has been somewhat theoretical.

LGIMA believes hedging a portfolio against mismatches between assets and liabilities at different points along the yield curve reduces DB plan risk better than a traditional LDI strategy. Lisella explains there’s still a lot of inherent volatility in an LDI strategy, because DB plan sponsors are not looking across the yield curve. She says DB plan sponsors need to “bucket” the liability profile, and at different points across the yield curve, look at where the liabilities stand, the plan’s exposure, and how the asset portfolio lines up against that.

Using a market-based benchmark means that benchmark is based off bond issuance in the market, Lisella points out. “A market-based benchmark looks at the universe of the given criteria of whatever benchmark you’re using and says, ‘Here are all the bonds that meet that criteria,’ and that’s what we’re measured against.” The problem is that the fixed-income market has a lot of 10-year and 30-year issuance, but not much in between, Lisella explains. The benchmark might average out to a 12- or 13-year duration, but at various points along the curve the bonds that meet the benchmark criteria may not have much commonality with the plan’s liabilities, and a plan could be under-hedged in some places and over-hedged in others.

To mitigate this risk, LGIMA may target a 75% hedge ratio, for example. This means that if the liabilities in a plan change by $100 million, the plan’s asset portfolio is going to change by $75 million. “And that’s how we’re measured,” she says. “It’s risk mitigation and attribution around that, as opposed to just beating a benchmark—because beating a benchmark doesn’t mean you have not lost ground in your funded status.”

Adding a hedging portfolio limits exposure, Lisella says, and it is not difficult to do, because it builds on what is already in place in the plan. “It adds another layer of precision to reduce that exposure and to reduce the risk that is presented when the yield curve doesn’t move in a parallel fashion.” If rates moved up and down at the same level, everything would be fine, but not if long rates go up more than short ones, or the other way around. “Typically, interest rates do not move in parallel,” she notes. “So the plan is exposed at different points along the curve.”

When implementing liability benchmarking in a DB plan, the underlying managers will continue to run the long-duration portfolio, generate alpha and everything they’ve been doing all along. All that is needed is a completion manager to run a fixed-income portfolio, Lisella says. “That manager will construct a custom hedging portfolio that goes over the top of all the underlying fixed-income benchmark to meet these strategic hedging objectives that are very specific to the liabilities in a plan,” she explains. “It’s an added layer of governance that also reduces risk.”

Plans that are not ready to fully implement this strategy are looking at it, and most are willing to increase their hedge ratio. More than one-third of LGIMA’s clients (37 out of 80) use some element of customization, Lisella says.

Chief financial officers and treasurers want to take risk off the table in a prudent way, Lisella notes. They have day jobs and other retirement options to focus on. “The last thing anyone wants to hear is that even though the plan’s assets outperformed the benchmark, the funded status still dropped,” she says.

“With this approach, we’re trying to avoid surprises at committee meetings,” Lisella adds. “It’s like saying you went on a diet and went to the gym all week and didn’t lose any weight. It really depends on what a person sees as diet food or considers a workout"—the theory and the practice may not line up precisely enough.