The vocabulary of liability-driven investing (LDI) seems familiar enough in the pension plan world, but that doesn’t mean that all plans find it easy to forgo the old ways, even when they can, says one observer.
“We did our first LDI portfolio back in 1989 — and we were almost like Don Quixote, going door to door and talking about asset-liability management and that liabilities have a return,” explains Sean McShea, an advisor at Ryan Labs Asset Management, a Sun Life Investment Management company. “LDI or LDI frameworks now are really very much in the vernacular, and in the public domain.”
While 50 percent of his clients have embarked on an LDI framework, McShea finds that some cling to the old ways — and old assumptions. “They’re still tied to historical financial fictions about pension expense,” he notes. “They have an assumed rate of return for assets and an assumed rate of return for liabilities forever. There’s a free lunch because the assumed rate of return of assets is greater than the assumed rate of return of liabilities.”
The Canadian experience
The average pension plan in the U.S. is about 83 percent funded. In Canada, plans have fared better, says Brent Simmons, senior managing director, defined benefit solutions, at Sun Life Financial. When they look at their two-decade roller-coaster ride of funded positions, however, some plans are feeling “regret risk.”
“Yes, it’s been a roller-coaster ride, but there’s actually been four distinct periods of time in Canada where most plans were fully funded,” he points out. “With perfect hindsight, they could have taken risk off the table at these points. Now is one of those points.”
Taking risk off the table requires a more holistic approach, Simmons thinks.
“Some plan sponsors,” he notes, “are saying the best place for me to take risk, if I have a limited amount of risk to take, is in my core business. I have a competitive advantage in my core business; I can do whatever I do — say, manufacturing widgets — better than my competitor down the street. By taking risk in my pension plan, I’m not introducing any special competitive advantage.”
It’s not just a holistic approach that counts. Plan sponsors and consultants have been in the pension business for a long time — and in much of that time, plans were in an accumulation phase. Now, says McShea, they are in de-accumulation. Although “the sponsors have got the wherewithal and the overall capacity to go to the bank and write the cheque for contributions, they really need to understand how their funding volatility can change. It can happen with the sequence of returns, a market correction and through the fact that we’re in a de-accumulation phase.”
With that understanding comes something else: benchmarking. Plans need a standard to measure how their liabilities behave. In turn, that can bring a better understanding of asset management.
Says Simmons, “The difference between your liability and your benchmark is in the investment constraints that you decided to impose. But then the difference between your benchmark and your investment manager performance is your value add, so you can actually see what the manager is doing and know that they’re doing what you hired them to do.”