The considerable traction gained by liability driven investing (LDI) both in Canada and abroad is well documented. Ongoing challenges to pension plan funded status stemming from weak equity markets and declining interest rates during the past decade have surprised some and, almost certainly, disappointed most. The growth and maturity of pension plan liabilities and the migration of global regulatory and accounting frameworks to a market value focus mean many trustees and plan sponsors have significantly shifted their perceptions of investment risk, as well as their willingness and ability to take on this risk.

LDI is a process for developing and monitoring investment policy relative to some measure of the benefits and/or expenditures that the invested assets are intended to fund. A key strength of LDI is that the framework explicitly links the three key policies that guide plan fiduciaries—benefits, funding and investment—and clarifies the role of each policy in delivering the underlying benefits obligations.

It’s important to emphasize that LDI should not be equated with minimizing risk or investing entirely in bonds. LDI is a process, not an outcome. Any investment strategy that reflects the ability and willingness of plan fiduciaries to take risk relative to the obligations they are looking to fund is an appropriate LDI strategy.

Risky Business

Most investments are a package of one or more risks that provide investors with an expected return above the risk-free rate. The following highlights four key risks and current trends in pension plan investment strategy and what many plan sponsors are considering and doing.

Interest rate risk – This is the risk of changes in asset values due to changes in interest rates. Assets that pay out a steady stream of income—most notably bonds but also dividend-paying stocks, real estate and infrastructure—are also affected. The market value of pension liabilities is also sensitive to changing interest rates, and one of the more popular trends in recent times has been matching the interest rate sensitivity in bond portfolios to plan liabilities.

Credit risk – A bond is really nothing more than a loan and, if you lend money to anyone other than the government, you risk not being paid back. Investors taking on this risk obviously want to be paid for it in the form of higher expected returns. Corporate bonds have been a prominent feature in fixed income portfolios for many years, and many plans have been taking the opportunity of much higher yields as a result of the credit crisis to increase corporate bond allocations.

Equity risk – As an owner of a business, your return depends on the profitability of the company, which can vary greatly from year to year, resulting in equity risk. Whereas bonds provide a fixed stream of income into the future, the profit stream you enjoy as an equity investor is less reliable. Recent trends include a reduction in equity allocations to asset classes such as real estate or other alternatives.

Illiquidity risk – While not all investments can be sold immediately at the prevailing “market” price, many investors are prepared to pay others to take on this risk. And pension plans that do not have immediate liquidity needs can afford to assume a certain amount of illiquidity risk as a further way to increase returns. Many plans have been examining and adding illiquidity risk through mortgages, real estate, infrastructure and other alternative assets.

The LDI Framework
Any LDI strategy must begin with a framework, which involves five key steps.

1. Establish one or more liability benchmarks: Many plan fiduciaries face the challenge of having to manage several liability measures (going concern, solvency and accounting). Trustees may establish a primary benchmark based on the liability measure with which they are most concerned. However, tertiary benchmarks may also be established to monitor progress of the investment strategy against other objectives.

2. Identify the MRP: The minimum risk portfolio (MRP) is an investable portfolio of securities that best matches the investment characteristics of the liability benchmark. The portfolio construction process starts by analyzing the liability cash flow structure for sensitivity of the liability value to changes in the interest rates and inflation. The MRP invariably will be a portfolio of nominal government and/or real return bonds.

3. Add investment risk and expected return: The MRP may be a suitable strategy for a plan that has little or no ability or willingness to take investment risk. However, many plans are able and willing to take on investment risk to pursue higher expected returns. Such risk may take the form of interest rate risk, credit risk, illiquidity risk and/or equity risk. The most appropriate combination of investment risks will depend on the investment beliefs of the trustees or plan sponsor and the size of the plan’s risk budget (see “Risky Business,” p. 43).

4. Set an appropriate policy benchmark: Based on the previous step, most plans establish a policy benchmark that reflects the chosen investment strategy. The policy benchmark combines a variety of public indexes that best represent the asset classes included in the investment strategy.

5. Track investment policy and implementation: There are two key aspects to tracking an LDI framework. Monitoring performance of the policy benchmark relative to the liability benchmark or MRP is an evaluation of policy decisions by plan fiduciaries to invest in strategies other than the MRP. Monitoring performance of individual managers and overall fund performance against the policy benchmark (or a portion relevant to their mandate) is an evaluation of implementation decisions, including manager selection and tactical asset mix decisions.