An LDI Strategy
The current defined benefit talk is mostly about "de-risking" plan assets, which means reducing the risk that any newly earned increase in funded status may deteriorate. This means adopting a liability-driven investment (LDI) strategy, with a primary focus on decreasing the variability of a defined benefit plan’s funded ratio. This requires an increase in the correlation of plan asset returns with those of plan liability "growth." Matching the sensitivity of plan assets and liabilities to changes in interest rates is the first step in the process, and the most important. It can be done with some combination of Treasury coupon bonds, Treasury STRIPS, investment grade credit bonds or derivatives of various maturities, by matching the overall interest rate duration and convexity of plan assets with the overall duration and convexity of plan liabilities. Closely matching the liability’s sensitivity to changes in credit bond spreads, on the other hand, is normally more of a challenge. Future benefit outflows are required to be discounted to present value based on the blended yield of a high-quality corporate bond index. But, this index is effectively un-investable, because many of the bonds in it are often unavailable for investment.
As a result, fully implementing an LDI strategy covering all plan assets requires the manager(s) to have an understanding of not only the pension liability calculation, but also the size, liquidity and duration of the corporate bond markets and the construction of a well-diversified portfolio of fixed income strategies. Even so, liability hedging portfolios will inherently exhibit some tracking error compared to the liabilities being hedged.
Implementing an LDI Strategy
Step 1, or the first layer, is the Liability Hedging Portfolio. The ideal Liability Hedging Portfolio consists of a well-diversified basket of A to Aaa-rated short, medium, and long-term government and credit bonds with an overall interest rate duration, credit spread duration, convexity, and yield profile matching that of the plan liabilities. Such an optimized basket of plan assets will track with, or hedge, plan liabilities when the latter is discounted to net present value (Present Benefit Obligation[PBO]). If plan assets rise and fall in the same manner and degree as plan liabilities, the risk of a decrease in the Plan’s funded status and funded ratio is minimized. Unfortunately, so is the "risk" that the funded status improves. Furthermore, defined benefit plans that are underfunded (Plan Assets < Plan PBO) ultimately need to make up that ground.
Thus, the next step for many is to increase the basis risk of the Liability Hedging Portfolio, in hopes of increasing its return profile without changing its correlation with plan liabilities. Most often, this involves extending the bond portfolio to include a sizable allocation to BBB bonds (higher credit spread duration), while keeping the maturity profile unchanged. More aggressive plan sponsors will sometimes include high yield bonds, Dollar-denominated sovereign bonds, and Treasury Inflation-Protected Securities in the hedging portfolio.
Allocations to each of these extended bond categories will increase basis risk and reduce the portfolio's liability hedging effectiveness. In exchange for that, the hoped for outcome is an increase in the current return of the Liability Hedging Portfolio versus the blended liability discount rate, which is the same as "good" tracking error. That said, the primary focus of an LDI mandate is to avoid adverse outcomes versus liabilities, rather than generating excess asset returns. This is even the case if the liability hedge returns are highly negative in the short term, or expected to be. The reasoning is that if plan assets are declining in value, then so are plan liabilities.
The next step, the second layer, is to move some assets completely away from the high correlation liability hedge portfolio, seeking out a diversified set of market exposures with higher expected returns than the long duration investment grade corporate bond index. This is the bedrock of the Growth Portfolio. The natural first allocation for this return-seeking portfolio is a diversified basket of U.S. stocks, followed by investments in developed market non-US stocks, and then emerging markets stocks. The stocks allocation normally extends to include all "growth" and "value" strategies as well as small-, mid-, and large-cap exposures.
The basic concept is to create an appropriately sized and diversified return-seeking portfolio to exist alongside a liability hedge portfolio. The liability hedge allocation provides some anchor for the funded ratio, depending on its size, while the returning-seeking portfolio helps to close the funding gap over time by producing long-term returns greater than that of the blended liability discount rate. Much of the second layer Growth Portfolio can be accomplished with index funds. Some plan sponsors will sometimes include high yield and global bonds in the basic Growth Portfolio mix, in order to reduce its expected volatility.
The third layer in our investment framework refers to stepping up the Growth Portfolio's diversification and management, thereby boosting its expected return relative to its expected volatility, by augmenting the investable universe and adding active management (i.e., Alpha potential). Alternative investment strategies comprise the biggest element of this third layer, nearly all of which are "actively managed". These include private equity, direct real estate, commodities/natural resources, and hedge funds.
In Conclusion: Managing an LDI Strategy
An LDI strategy has a number of "moving parts" for plan sponsors -
- Having initially built an optimized Liability Hedge, you will need to maintain over time the Hedge portfolio's appropriate exposure to your plan's Liability Risk Factors, which change. This essentially involves periodically re-optimizing the Liability Hedge; The Growth Portfolio can be straightforward (a basket of diversified index stock funds, allocated along some market metric, like global market cap) or an extremely complex brew of actively managed public equity mandates, private equity and real asset positions, high yield and unconstrained bond funds, etc. The latter comes with many more opportunities for improved performance, and many more ongoing management challenges and costs along the way;
- Perhaps the most important ongoing issue is bringing everything together, by determining the size of the Hedge Portfolio relative to the size of the Growth Portfolio. One offers risk reduction specific to funded status variability, while the other offers to ultimately reduce the size of the funding gap. Both are critical;
- In order keep things rational, many plan sponsors rely on the concept of a Liability Hedging "Glidepath". Here, the target allocation between the Hedging and Growth portfolios varies as a direct function of the plan's Funded Ratio (FR). The higher the FR gets, the greater the plan's exposure to hedging investments. The lower the FR falls, the greater the allocation to growth assets.