W: Doug, you have considerable experience working for the Shell Pension Plan prior to joining Western Asset, did Shell implement a LDI strategy while you were there?
D: No, but we actually began to have a conversation and explore asset allocation solutions that would reduce the riskiness of the assets relative to the liabilities when the plan was materially overfunded in late 1999. Even some 17 years ago, the concept of focusing on a more LDI driven approach was being explored - but was certainly not in vogue at that time.
W: What makes you different in implementing an LDI strategy? What makes your implementation unique?
D: When we begin a conversation with a client we try to build trust through demonstrating our experience. Western Asset has been managing long duration assets for 26 years, and we have about $50 billion in long duration assets under management. First we try to understand their existing assets and how those assets are positioned relative to their liabilities. A tool that we immediately employ is what we call our LDI Optimizer Model. This model allows us to project a client’s cash flows for their pension as well as information pertaining to their asset allocation and the discount rate that they use, as well as their associated discount curve. We apply all of those variables to the model and we generate a custom solution that can optimize on two levels. If the pension plan is still trying to hit a return target, it can optimize on that level. If they are trying to optimize in terms of creating an asset mix that very closely mimics the performance of their liabilities, we can also optimize on that level. So, the proprietary model that we employ provides two types of output and it also compares both of those optimized scenarios against adverse market environments such as what we experienced in 2008. We can also vary the capital market assumptions for returns of various asset classes over the coming years. So the first step we really take is to take their data, their cash flows, their discount rates, discount curves, asset allocations, any ideas, and projections they have around asset returns, and run that custom solution so that we can have an intelligent discussion around how their assets are currently positioned. Are they achieving their objective? This creates a dialog from which we can help construct an asset strategy that may be preferential relative to their existing assets.
With this in mind one of the key tenants of our philosophy here at Western Asset as it relates to LDI, is that simple solutions can be highly effective. If you think about where most defined benefit plans are at today their typical asset allocation is somewhere along the lines of 55%/45%. That is 55% risk-seeking assets and 45% hedging assets. Certainly when LDI came into vogue around 9 to 10 years ago, following the passage of the Pension Protection Act, we thought you would see fairly aggressive moves into de-risking. However if you examine the funding history of the corporate pension plan community it has been challenged to say the least.
Unfortunately as you probably know the corporate pension plan community is fairly underfunded at this point, probably around the low 80% range. Quite frankly that creates a challenge for plan sponsors in terms of implementing de-risking strategies because they are too many funding points in the hole. This is certainly true over the past few years with the equity market producing mediocre returns and interest rates continuing their downward trend. So that has obviously had an adverse effect on the valuation of liabilities.
W: How do you go about implementing these strategies even when there are barriers in the way?
D: We look at both sides of the balance sheet. We pay close attention to both the asset structure as well as the liability structure. A plan sponsor might not quite realize the extent to which they have mismatches, and really how much risk their assets have relative to their liabilities. We develop our view of the risk of their assets relative to that of their liabilities and present that to them.
We try and understand their objective. From there we examine the structure of their assets relative to their liabilities and try to determine if there are more optimal approaches to their investment objective beyond funded status. Do plan sponsors see that their funded status dropped from 85% to 80% quarter over quarter? Absolutely! Do they understand what sources caused that 5 percentage point drop? We certainly try to isolate that for them and quantify that for them.
W: What are some new trends in LDI?
D: One of the trends that we have started to see is a throwback to an old asset strategy. The strategy is more or less taking a beta source like treasury duration through treasury futures and putting it in an alpha source. So the old alpha/beta separation is trying to create more excess returns over the beta source than in a long credit type approach. We are seeing some plans begin to consider that approach. It is much more aggressive. We have a more aggressive investment solution that is attempting to achieve LIBOR plus 4 over treasury duration. This would get you a pretty attractive excess return profile. You would be comfortable living with volatility year in and year out as a means to shore up that funded status that we spoke of earlier. We are starting to see some plans “stretch” a bit in terms of the asset strategies that they are willing to consider implementing. We have one large client right now, very smart, that is going to implement a more unconstrained approach that we manage here at Western Asset, and marry that with a treasury duration approach.
W: Is that Total Return Unconstrained (TRU)?
D: No it is more aggressive than that. It is our macro opportunities product, which runs at a 8% to 10% annualized volatility target. They are looking at the correlation profile of that product relative to equities, hedge funds, even traditional high yield, and so forth. We have been fortunate, it has had a very favorable return history and an extremely favorable correlation profile to those traditional asset classes. If they were sitting at 98 percent funded status you may not see that approach, but since most plans are somewhere in the low 80’s right now, you are starting to see some of these plans start to consider, more aggressive approaches instead of de-risking
W: How much of that is pessimism on fixed income beta? Q4 only rewarded for treasury long-duration while the credit-spread managers suffered. How much of this approach is desperation, funded status glidepaths simply won’t improve without alpha.
D: Yeah, I think about this a lot to be honest with you. I think a lot of behavior has been driven by that very fact. Let’s have a conceptual conversation. If you’re 80 points in the hole and you are going to be paying out 6-7 percent of your funds to pensioners this year, you’ve got that as a headwind. If you come up with reasonable capital market forecasts in equities and fixed income you’re probably at best “pushing on a string” this year. Right? You’re not going to be improving your funded status this year. You might, but doubtful. So they are saying, “well ok, we can’t just sit here and spin our wheels forever.” So they are considering more creative approaches.” For example in 2015, if you look at long credit it materially underfunded comparable duration treasury and actually that was a repeat from 2014. Our long credit product was fortunate because we had favorable sector and security allocations last year. We actually outperformed the long credit index by 189 basis points in 2015. So that type of active management, which is a fundamental belief of ours, helps you keep up with your liabilities. If you produce 200 basis points on the credit mandate; that is something that helps you shore up that funded status gap slowly. Plan sponsors when they look at their asset allocations they need to think rather keenly about their risk return profile of that asset class relative to their liabilities, whether or not it is going to shore up that funded status.
W: Your goal is 100 basis point increase of alpha is that correct? And why is that your goal?
D: It depends on the client’s risk and return objectives. We have some clients who say “get me 50 basis points, go get me 100, 125, just to keep up with the liabilities,” which are all effected by inflation, actuarial changes, etc. If you think about actuarial change and how average life expectancy got extended out, that had a 6 to 8 point drop in the funded status on the average pension plan. The reality is people are living longer and if they’re living longer than they’re getting a pension check for a lot longer. Which causes liabilities to move up, and durations to extend out. In our view if you’re implementing a more full LDI approach, and there are very few plans out there that are doing this right now, you have to produce excess returns above a passive benchmark to have any hope of keeping up with your liabilities.
W: Just for clarification, are you suggesting that actuaries are underestimating the amount of future liabilities because longevity is increasing faster than they have to apply it?
D: I think they’re putting up realistic expectations of life expectancies, and as a result it is causing liabilities to move up, and durations to extend out. I think they are trying to help pension plans be realistic in terms of that cash flow stream that goes to that pensioner. I am a guest professor at my alma mater and when I teach I go to this chart that goes back to when I graduated. I put up that chart that shows how things were when I graduated compared to how they are today. The life expectancy average when I graduated was a little bit higher than age 75 and today that number is a little higher than age 79. So if you think about that percent increase over a fairly small period of time that’s material. They will probably continue to shift out those life expectancy curves as lifestyles and technologies continue to improve over time. And that would put a further damper on improved funded status. When that increase was released in mid-2014, it started hitting corporate pension plans not too soon thereafter, and it dropped funded status by 6-8 points, which is huge!
W: Are there any other tools that you use or provide to your clients to show the measured success of the strategy?
D: Yes, for those that are implementing asset strategies that are tied to the movement in their liabilities. We have a simple attribution tool. We use that tool to understand the movement of the assets that we manage relative to the liabilities. It’s good, it’s not great, there’s some noise in it but at the end of the day it is still what you are looking at. Some of the discount curves that our clients choose quite frankly are un-investible. If you are using this discount curve to value your liabilities, we have to advise the asset strategy via some benchmark that we use that somewhat closely mimics the movement of that discount curve. When you get down to that finite of a level it is hard to devise an asset strategy that will closely mimic the performance of your liabilities which are discounted based upon a curve that is not investable. But that’s a finite, finely tuned strategy for a plan that is fully de-risking and doesn’t want any noise between the assets and the liabilities.
W: Is there anything else you would like us to know about Western Asset Management, and what you can do for plan sponsors?
D: I think our experience in this business, having 26 years managing long duration, our full commitment to this business, and having analytical models that is noteworthy. Our continued research for years on LDI, and having written extensively on the topic, we have some very intelligent people here that have followed through with some very insightful whitepapers on LDI insights. All of this makes us a real player in this business. The one thing that differentiates us is that we are very client centric. We are not so big that we lose sight of who you are, our client is the most important thing to us. We spend a lot of time working with our clients. We try to be a partner with our clients and try to be a value added resource, because we believe that being the first call for intellectual capital is a way for you to keep and gain business. That is our approach here. We try to hire nice people, smart people, and we talk at a level that everybody can understand. One of our principal tenants of our LDI philosophy is keeping things simple. Simple solutions are really the most optimal solutions. We try to break down problems into its most basic elements and have a conversation that everybody understands and everybody can buy into. It’s not an overly complicated process; it’s not a black box. We are just trying to give people a good experience and perspective on LDI. That is something that I emphasize a lot, handholding and close client interactions. We make sure that we give our clients our full attention. It’s their money, and we make sure that we give them solutions and investment performance they expect. That is what we are all about here.