5. It is unwise to implement LDI when interest rates are so low.
The issue of low rates is clearly debatable and is perhaps the most prevalent LDI topic in the current economic environment. There is no question that a plan with an asset/liability interest rate mismatch would stand to improve its funding ratio if interest rates move higher. As previously noted, an LDI framework identifies potential risks that can affect the volatility of the funding ratio. Maintaining a large interest rate or duration mismatch will increase that volatility.
LDI focuses on removing unrewarded sources of risk—in this case, interest rate risk—because predicting the direction and level of interest rates over time has proven to be a difficult task. Instead of, At what level of interest rates should we implement an LDI strategy? the question should be, How much interest rate exposure is appropriate for the plan?
The debate around interest rates should begin with two key risk factors: current funded status and current interest rate hedge ratio. Regardless of the level of interest rates, interest rate mismatch should be viewed as an active element within the investment policy. For plans that are fully funded, the appetite to take on interest rate risk should be low. Gains from taking active interest rate positions come with a greater downside than upside, as a fully funded plan could fall into an underfunded status when interest rates fall.
Figure 2 illustrates the potential consequences of a declining funding ratio. Conversely, well-funded plans gain little from further increasing their funded status if interest rates rise, since those gains cannot be removed from the plan and used by the sponsoring entity for other purposes.
For those plans with a view that interest rates will rise, actively managed or gradual implementations of interest rate hedging programs can assist them in taking advantage of higher interest rates. These types of strategic and tactical programs can be implemented by setting execution points based on specific funding ratio targets or interest rate levels. Options strategies can also be used to provide upside potential while protecting the funding ratio on the downside. The decision to extend duration for all assets versus fixed income assets alone is largely a function of a plan’s funding status and the plan sponsor’s degree of comfort with assuming risk.
LDI may or may not be appropriate for every plan. However, every plan sponsor should fully understand the concept and the factors that determine its applicability, as well as the various ways that LDI can be implemented. Only after a full review and complete understanding of these factors can plan sponsors make informed decisions.
Peter Lindley is vice-president and head of investments with State Street Global Advisors, Ltd. (Canada).
peter_lindley@ssga.com
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the May 2009 edition of BENEFITS CANADA magazine.