Trends in liability driven investing (LDI) continue to evolve as Canadian plan sponsors of all sizes put LDI strategies in place. Implementing these strategies has never been a simple exercise, because there are many factors to consider, including competing priorities.
As plan sponsors faced two major economic downturns in one decade—as well as the harsh realities of large pension costs, historically low interest rates, ongoing market volatility and slower economic growth—LDI quickly evolved from a marketing buzzword to a new normal framework in institutional investing for DB pension plans. But has the pendulum swung too far, with too much emphasis on precisely matching assets and liabilities within a narrow framework of prescribed rules? And what will happen when the next round of changes to solvency and accounting rules becomes a reality?
The next generation of LDI requires a long-term perspective in which risk is no longer (or not only) defined by regulations and accounting rules for measuring, paying for and expensing pension obligations. Does this mean abandoning past LDI strategies? No. But there’s a caveat: for plans with long time horizons, the next generation should include consideration of the true long-term economic costs within the larger context of the organization’s financial objectives and appetite for risk.
You say you want an evolution
The evolution of LDI has fundamentally shifted the roles of—and conversations between—plan sponsors, their asset managers and their consultants.
Historically, consultants’ rigorous asset/liability modelling resulted in a desired rate of return based on modern portfolio theory (a concept of finance that seeks to maximize an asset portfolio’s optimal rate of return for a given level of portfolio risk). The rate of return target was expressed in the form of a target asset mix, or a mix of market benchmarks or indexes (i.e., the typical 60% equity /40% fixed income mix).
The asset manager’s objective was either to efficiently and cost-effectively deliver a benchmark rate of return on a passive basis or to actively generate excess returns (alpha) relative to a given market benchmark. A passive asset manager’s performance was measured based on tracking error, or dispersion from that benchmark, while an active manager’s performance was measured by the value added relative to the appropriate market index. Conversations were not focused on the relevance of the referenced benchmarks to the behaviour of the obligations, and there was limited discussion about the risks embedded in the construction of the index itself or the securities included in it, either on an absolute basis or relative to the plan’s obligations.
A decade of volatile and predominantly sideways equity market returns—combined with declining interest rates and corresponding rising liability obligations—made it apparent that the traditional policy mix was too far from the minimum risk portfolio. This has led to a greater focus on risk budgeting and LDI.
In the early days of implementing LDI, many plan sponsors came to the same conclusion: the traditional 60/40 equity/bond portfolio had too much money invested in risky return-seeking assets. Even a plan’s fixed income assets, which were believed to be the closest match to its liability obligations, had too much uncompensated risk. The first step in reducing these risks was to better align the fixed income allocation with the pension obligations.
Historical solutions
The simplest approach was to shift the fixed income allocation to longer-duration bonds through strategies aligned with industry benchmarks such as the DEX Long Bond Index—a strategy known as duration matching. This strategy served to improve the overall hedge ratio relative to the obligations, thereby reducing interest rate risk. In the early days of duration matching, there was limited discussion about the actual bonds within the benchmark or the resulting altered corporate credit profile of longer-duration fixed income portfolios.
As duration matching evolved, the focus shifted to creating increasingly customized fixed income portfolios designed to more closely align with pension obligations. These structured solutions were either key rate duration-matched, where the overall term structure and interest rate sensitivity were aligned with the liability obligations or, more precisely, cash flow-matched, in which coupon and principal payments from the bonds were structured to replicate the pattern of payout obligations.
This concept continued to evolve into creating highly precise fixed income allocations designed to closely align with how pension plans are required to measure the present value of solvency and accounting obligations. In essence, the goal was to hedge the liability based on how regulators or accounting professionals measure these obligations.
This strategy may have been appropriate for fully funded and closed plans with highly predictable fixed obligations and 100% allocation to fixed income. However, for many plans that still had a significant allocation to equities, the attention to high precision in the fixed income allocation alone was less warranted and may have introduced unnecessary costs. (This is akin to a firefighter wearing the highest-quality fire-retardant pants topped by only a T-shirt.) In addition, the focus on precision carried with it a false perception of accuracy, because how liabilities are measured, paid for and expensed is a moving target.