Funds which had an LDI focus in 2008, typically defined as having a high fixed income content, did exceptionally well, although most would admit to having spent several years convincing their stakeholders of its merits. Moving to LDI in 2009 or 2010 seems suspiciously like closing the barn door after the horse has bolted, taken a slow boat to China and retraced the steps of Marco Polo to Venice.
What factors might affect an LDI implementation at this point?
Interest rates
Long interest rates have declined by 50 basis points over the last few months. Betting against rising rates would appear foolhardy at best. However plan sponsors should recall that risk is a function of probability times magnitude of impact.
So although the probability of declining rates may be far lower than the probability of rising rates, the impact may be quite significant. If long rates rise (as expected), liability values would decline by material amounts, which would by only partially offset by declining values in fixed income portfolios. Equity portfolios might well provide positive returns in this environment, so that funding ratios under these circumstances could still show healthy gains.
However, if rates decline (in a Japan-like scenario) liabilities could increase by 15%-20%, for which rising fixed income portfolios would only provide a 5%-10% offset, and poor returns in corporate bond mandates or equity portfolios could exacerbate the situation, leading to funding ratio declines of a further 10% or more from current levels. Can plan sponsors afford to take this risk without doing as much as possible to defend the portfolio against lower rates?
Inflation
Real return bonds provided a unique buying opportunity in late 2008, posting returns of 14.5% for calendar year 2009. Admittedly these returns contrasted with even higher returns for corporate bonds (19%) and for Canadian equities (35%). However given the level of ongoing debate about inflation vs. deflation prospects, a pension fund might be well advised to establish a modest portfolio of real assets, ahead of any pending regulation to this effect.
Alternative assets
Many alternative assets, such as real estate, provide attractive LDI characteristics. Asset-liability models credit real estate with income-producing capabilities, inflation hedging features, and the benefits of lower volatility in valuations. However for those who prefer to focus on returns, rather than risk reduction, the experience is equally compelling.
For the ten year period ending Dec. 31, 2009, real estate returned 10.3% annualized (with a volatility of 4.3%) whereas the TSX (capped) returned 7.2% annualized (with a volatility of 16.5%). Most global equity markets had negative returns over this time period. Over longer periods, (25 years), real estate returned 9.2%, which compared favourably to Canadian equities at 10.4% and long bonds at 10.8% during a declining rate environment. Real estate provided lower volatility than, and low or negative correlation with, all traditional asset classes.
Like the proverbial oak tree, the best time to implement LDI may have been ten years ago, but the second best time, in light of risk tolerance, mark-to-market pressures and market uncertainty, might well be right now.