Liability driven investment (LDI) can help DB pension plans match their assets to their liabilities. But it’s not an approach adopted by every plan.
Rob Stapleford of Mercer and Duncan Burrill of the CBC Pension Plan spoke about the barriers to LDI and the lessons learned from implementation at the ACPM’s Ontario Regional Council spring session—The New Normal for Investments and Other Updates—held in Toronto earlier this week.
Barriers
Stapleford set the stage for the discussion with a look at some of the possible barriers to LDI.
First, there’s the issue of identifying the right LDI strategy for the pension plan, as there are several strategies to choose from: long duration bond, longevity swaps, interest rate hedging, leverage, etc.
“One of the biggest problems with LDI is defining what it is and what it is not,” said Stapleford.
In terms of governance and education, Stapleford emphasized that the pension plan’s governing body has to be clear on the objectives and understand that some of these LDI strategies are not going to work in every situation.
“There is a risk/return element to the LDI decision, but often, the return gets the emphasis,” he said. “The other part is the risk.”
Plan sponsors need to educate their governing body about derivatives and leverage, as well as manage the governing body’s concern about headline risk.
They also need to think about the timing, pace and how to implement the strategy. Figure out the how, said Stapleford. “The pace and time can be modified as you go forward.”
While LDI strategies can take a bit more administrative work, Stapleford said that a plan sponsor can look to many providers for help. Plan sponsors should also remember that benchmarking and monitoring are a little different in an LDI strategy, so they should change their expectations and their mindset in operating the plan accordingly.
Cost is a concern for many pension committees—many worry about the increased costs of alternatives and global equities—but Stapleford said to keep it in perspective, in terms of the goals of the strategy and the assets under management.
Some LDI strategies involve lower allocation to public equities. Within those strategies, many plan sponsors want to maintain a higher allocation to Canadian equities, based on past returns and the belief that there is higher correlation to liabilities. However, correlations of Canadian equities to Canadian fixed income benchmarks are not materially higher than those for global equities.
Despite the barriers to LDI, Stapleford asked the audience, “Can you afford not to look at some of these strategies? Doing nothing, waiting for the equity markets to turn around or interest rates to rise, means you’re probably still going to struggle.”
CBC—a case study
Burrill continued the second half of the presentation, illustrating how the 18,000-member CBC Pension Plan dealt with some of the barriers mentioned above.
The CBC Pension Plan—established in 1961—adopted its LDI strategy in 2005 and implemented it over two years.
The plan had a small solvency funding surplus at implementation and though it used external advisors, it did develop internal expertise.
“We have an internal staff at the pension fund and had the capacity to do that,” Burrill said.
“For our fund, [LDI] has been helpful in terms of keeping the funding ratio onside,” he said. “We chose the solvency liability-matching and return-generating approach because we wanted something that balanced costs and the de-risking that we wanted to take,” he explained.
The plan focused on dollar duration matching and implemented a derivatives overlay using total return swaps and bond forwards.
“The bond overlay allowed us to lower equity exposure,” he said. “We got this carry that we would expect to get on a regular basis.”
Governance
Burrill could not stress enough that education of the pension board is critical; the board should understand the objective and the LDI strategy.
“You’re asking the board to go out on limb and use a strategy that not everyone else is using. They have to believe in it.”
The CBC Pension Plan has two days of training for new trustees, including internal meetings with managers, actuaries, etc. There are four full-day board meetings a year, and every meeting has an education session.
“We put a lot of emphasis on board education and it’s paid off,” said Burrill.
The CBC board also had to know how it was going to measure the performance because LDI requires a very different way of reporting (i.e., in comparison with the liabilities).
“We had calculation of liabilities right on the monthly statements,” said Burrill.
Boards get nervous when you mention derivatives, said Burrill. Derivatives create leverage, liquidity and counterparty credit risk and exposes the portfolio to systematic banking risk.
“But all derivatives are not the same,” he continued. “The worst stories you’ve read are of credit default swaps. In our strategy, there are checks and balances in place.”
Burrill reminded the audience that risk goes with the LDI territory. “LDI does not eliminate plan risk. It increases certain risks—counterparty risk, model risk, financial reporting risk, liquidity risk—and those risks have to be managed,” he said.
“Plans have to go into [LDI] with their eyes wide open and realize what they’re getting. It’s not a panacea.”