Although the concept of liability driven investing(LDI)is somewhat new for Canadian plan sponsors, it has been around for much longer.
“The annuity business is an old business and life insurance companies have been writing annuities for a long time,” said Tristram Lett, managing director of Integra Absolute Return Strategies, at yesterday’s LDI 2006 Forum in Toronto. “And you really don’t have to think about how they invest the money that backs these annuities to realize that LDI’s been around a long time.”
The interest in LDI has grown as of late as long-term rates are considerably below actuarial funding rates. This has an important impact on corporate plans through eroding surpluses and creating deficits.
“Plan sponsors set policy; they should hire professionals to execute strategy,” Lett explained. “My point is it doesn’t matter where rates are going, plan sponsors should be actively gauging in an LDI plan. They should not be engaging in the interest rate guessing game.”
When it comes to liability driven investing, one of the issues plan sponsors need to recognize that they have a mismatch in the inflation sensitivity and the interest rate risk of their assets to their liabilities, said Steve Illot, head of fixed income at Aberdeen.
“The second issue for clients is really to reevaluate whether their current asset allocation framework or asset allocation mix is appropriate in relation to the least risk portfolio.” There’s also another issue, he said. “If we enter into over-the-counter contracts with investment banks, pension funds adopt credit risk with the investment banks. How’s that managed? How certain can we be that these investment banks will be around in 30, 40, 50 years to repay their obligations?”
When it comes to client reporting, there are numerous questions that need to be answered: How do you report on derivatives? How do you measure performance? Do you measure that against the liabilities?
“People are not comfortable. We’ve grown up in the last 20 years in an industry where we spend more time worrying about managers’ performance against benchmark than we do worrying about assets versus liabilities,” Illot said. “So that’s a change for people to get used to.”
Plan sponsors need to change the benchmarks that they’re trying to match, according to David Greenleaf, State Street Canada’s vice president and head of tactical asset allocation. Many plans are benchmarked against a duration of about 6-1/2 years. However, plans might have a liability stream that’s much higher than that, somewhere in the 15-year range, for example.
“That’s fairly simple to do,” he said. “What they’re effectively doing is they’re moving the duration of their fixed income assets in the right direction.”
To match liabilities, pension plans have a number of products to choose from, such as swaps and futures. There are some limitations here in Canada to the availability of longer-duration futures to use. There is also the introduction into the marketplace of vehicles that can simplify the swap investment process for plans, such as pooled swap funds.
“The idea there is that a plan can move with that type of vehicle from a fixed-income structure that has a certain duration to a fixed-income structure that comes much closer to matching the duration and the duration of its liability streams effectively,” said Greenleaf.
Certainly as liability driven investment is being talked about more and more, many practitioners are coming forward with many suitable alpha strategies that can be married or matched to those liability driven.
“One of the advantages of liability driven even if you don’t employ the strategy, it does break the boundaries. We’re looking everywhere potentially,” John Pluta, senior vice-president at Declaration Management, said. “That open boundaries aspect of liability driven potentially allows the manager more choices, more capabilities. If they have skill in those areas that could make for a better, more diversified portfolio.”
There are many options available to invest in the fixed-income market. In the U.S., he pointed out three areas of investment grade credit: investment grade corporate bonds, agency and sovereign debt, and structured credit, which includes credit cards, student loan receivables, mortgage product, etc.
“I think the best alpha strategy, especially if it’s to fit well with a liability driven beta, is a strategy that can employ each of these,” Pluta said. “There are times when you want to be involved in corporate credit for sure. There are the spread volatilities that can offer trading opportunities. But you also want to be involved in these other areas, which may be quite underrepresented in your pension plan.”
Liability driven investing introduces the aspect of short-term investing for plan sponsors, but they still keep the long term in mind. Industry expert Wendy Brodkin said the reason the short term is introduced now is these plans are a lot more mature, the demographics are a lot more mature and more skewed the short term than they were before. And she thinks long term versus short term is one of the most interesting things out there in the world now.
“Now everyone goes down the route of LDI and has this other return-seeking portfolio that’s diversified away from the equity market investments, what’s that going to mean for the short term performance of companies and how’s that going to change the behaviour?” she asked “I think it’s an interesting part of how the world’s going to change going forward with this new investing paradigm.”
The 2006 LDI Forum was sponsored by:
