Evaluating LDI

3 Derivative overlays versus long-only solutions – What are the issues involved?

Long-only LDI strategies (i.e., investing in a portfolio of long-maturity government and corporate bonds chosen to closely mimic the plan’s liability profile) may be very appropriate in reducing liability risk for fully funded pension plans, plans with a substantial surplus or those focused on full immunization rather than on asset growth. The main disadvantage of longonly LDI strategies is that in holding fixed income securities to reduce the asset/liability mismatch, the amount of capital available for investments with potentially higher returns is limited. Pension plans typically pursue long-only fixed income LDI strategies as a first step in reducing surplus risk.

An overlay strategy uses derivative instruments— typically, interest rate swaps—to add duration. One advantage of overlays is that they allow for both the hedging of the interest rate mismatch and the release of capital for investment in assets generating higher returns. The main disadvantages of overlays include complications in creating customized benchmarks, the inherent leverage, the requirement to pay more attention to liquidity needs and more complex

reporting requirements.

4 Broker/dealer versus asset manager solutions – What is the difference between hiring an overlay asset manager and adopting an all-in-one solution from a broker/dealer?

A traditional asset manager designs, executes and manages an overlay mandate for an annual management fee. Appropriately benchmarked to the pension plan’s liability profile, an LDI overlay is little different from any other fixed income assignment. Advantages include potentially more transparent execution costs, flexibility in accommodating changes to the liability profile or asset allocation and transparent measurement of long-term performance. In addition, asset managers act as fiduciaries subject to an investment management agreement. An LDI overlay overseen by an asset manager can include an actively managed effort to outperform the LDI benchmark.

By comparison, a broker/dealer typically executes a one-off, customized transaction earning a bid/offer spread with the potential advantage of no explicit management fee, but with no ongoing oversight or management responsibilities. Broker/dealer solutions can be designed with simultaneous buying and selling of options contracts to manage equity and fixed income market exposures while limiting upfront costs or payments. These solutions are designed to be “self-implementing” with respect to changes in interest rates or equity market levels, potentially freeing plan sponsors from the need to monitor the market closely due to option position exposures. The broker/dealer has no formal fiduciary duties.

5 Active versus passive LDI management – What are the issues involved?

Passive LDI management includes the hedging of interest rate risks through a passive swap overlay and/or the selection of fixed income securities with the goal of matching the performance of a liability benchmark. Active LDI management seeks to outperform the liability benchmark by, for example, taking active duration positions versus liability cash flows, rotating among government, agency or corporate bond positions or making relative value security selection decisions. With actively managed strategies, investment managers are evaluated on their ability to outperform an LDI benchmark. In structuring an active LDI portfolio, a pension plan will define the LDI benchmark, target an appropriate risk/return profile relative to the benchmark and define any other appropriate constraints.

6 Collateral management – What is the appropriate type, amount and liquidity of collateral?

Collateral and liquidity are critical when duration overlays are used. Yet collateral requirements are often misunderstood— while potentially burdensome from an administrative perspective, they are also necessary for risk management.

When an LDI overlay strategy is implemented with swaps, the International Swaps and Derivatives Association, Inc. (ISDA) documentation usually serves as the legal framework governing the contractual relationship between the pension plan and the swap counterparty. ISDA documents are usually accompanied by a Credit Support Annex (CSA), which governs collateral. Cash is usually posted as collateral, but most CSAs also allow the use of other securities—typically, government and agency securities. An LDI overlay manager can use securities managed elsewhere for collateral purposes, but that may complicate the management of these other portfolio investments.

The best practice is to maintain a meaningful cushion of liquid assets as collateral in order to avoid rebalancing the portfolio too frequently or being forced to sell other assets. Enough cash or government security collateral should be maintained to cover a theoretical 99% probability of interest rates remaining below a specific level. As Figure 2 (see below) indicates, for the typical portfolio allocating 25% to 40% of its assets to fixed income, repurposing such an allocation to collateral could comfortably support an LDI overlay that hedges a substantial portion of a pension plan’s liability interest rate risk.