Today’s tactics
Some of the most creative LDI solutions today use derivatives, such as bond overlays, in their fixed income allocations. These synthetic strategies allow an investor to gain greater fixed income exposure per dollar invested. Initially, their primary purpose was to cost-effectively add significantly more bond duration, which hedged interest rate risk relative to mark-to-market liability measures (i.e., solvency, accounting). The bond overlay allocation was typically paired with other fixed income strategies to achieve a customized duration and interest rate hedge ratio target. (The hedge ratio refers to the degree of interest rate matching in the asset portfolio.) Many plans used the derivative bond overlay tool because it allowed them to add bond duration in a capital-efficient manner, raising the total portfolio hedge ratio while leaving capital available for return-seeking strategies.
While traditional fixed income benchmarks may be useful guideposts in the construction and measurement of a liability-driven solution, the benchmarks alone are not meaningful measures of a plan’s risks. Asset/liability matching for fixed income allocations is now more focused on obligations and is more holistic in nature, with the overall asset mix taken into consideration. Rather than simply asking a manager to meet or beat a benchmark outcome, this approach involves collaborative dialogues earlier in the design process, requires specific solutions to meet the unique circumstances and priority of objectives for the plan, and includes not just a solution prescription but also an implementation strategy.
Gen next
Recent changes to solvency funding rules and accounting standards provide an opportunity for plan sponsors to think about LDI strategies and implementation within the context of the long-term plan costs and risks to be hedged. For example, multi-employer pension plans are already exempt from solvency funding rules, and this trend is continuing, with certain jurisdictions also exempting some public sector plans. LDI is still important for these plan sponsors, but with more flexibility in the rules, they need to determine the right trade-off between the perfect hedge and the opportunity to take some risk to reduce expected costs.
While LDI has evolved with a focus on more precisely hedging the shorter-term mark-to-market measures of the obligations, the next generation of LDI will also include a longer-term view of economic value. Plan sponsors will likely place varying degrees of importance on matching solvency, windup and accounting metrics, recognizing that these measures can distort economic reality. It will be equally important to consider income generation and the search for return in a low-yield environment. Future investment portfolios could well include elements such as revised fixed income allocations, synthetic bond overlays, tactical opportunities to add yield, and equity strategies with a focus on reduced volatility and capital preservation.
Fixed income allocations will be designed to better match the plan’s obligations. For most plan sponsors, that means a continued focus on longer-dated bonds. However, the next generation of LDI will likely look beyond just duration matching based on DEX benchmarks and will more closely examine how the index is constructed, especially with respect to how and where on the maturity spectrum the plan should take exposure to corporate credit.
Synthetic bond overlays have evolved as an important tool in LDI because of their ability to significantly increase the duration match to asset/liability mark-to-market measures such as solvency or accounting. Bond overlay strategies can also provide a very good source of predictable income via coupon payments from the referenced securities. Synthetic bond overlay strategies increase the overall yield of the fixed income portfolio, because the larger notional exposure earns a yield that is higher than both the underlying reference benchmark and the financing cost. In fact, to reflect this higher yield, some plans use a higher rate to discount the going concern cash flows (the long-term obligations assuming that the plan continues indefinitely). This results in an immediate reduction in the current service cost and going concern liabilities.
Tactical opportunities to add yield and enhance return will come from a broad spectrum of assets, including corporate investment- or noninvestment-grade bonds, global bonds, emerging market sovereign debt and inflation-linked securities. In an LDI context, these sources of income provide a relatively stable overall return stream, which can result in lower overall volatility when compared with other options, such as common shares. High-yield bonds rank higher in the capital structure than common equity—an important consideration in LDI strategies that are focused on long-term capital preservation.
Equity strategies with a focus on capital preservation and reduced volatility will include investment in high-quality companies. To the extent that funds are allocated to return-seeking assets, such as equities, there is less emphasis on traditional cap-weighted indexes. Success will not be measured solely on the outcome relative to typical benchmarks. Instead, it will also be measured relative to the plan’s ultimate objective: namely, to reduce ongoing funded status volatility. In an LDI context, the focus will be on innovative strategies that deliver obligation-relevant returns in a risk-controlled fashion. They might bear a limited resemblance to cap-weighted market indexes, but they will deliver a more predictable and comfortable outcome for the pension plan sponsor.
In order to navigate the increasingly complex and uncertain future of plan risks, sponsors will need asset managers that understand their businesses well and are able to translate that understanding into financial implications for the plans, both on the liability front and on the investment front. After all, the future may be closer than you think.
Ingrid Macintosh is managing director; Nilesh Patel is vice-president and director; and Rachna de Koning is vice-president and director with TD Asset Management. ingrid.macintosh@tdam.com; nilesh.patel@tdam.com; rachna.dekoning@tdam.com
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