Updated with correction
More than a quarter of the country's largest pension funds are using a liability-driven investing strategy, according to data collected by Pensions & Investments.
Fifty-two pension funds, or 26% of those in the P&I Top 200, with total assets of $1.2 trillion and defined benefit assets of $752 billion, have reported using LDI to better match investments to their pension liabilities, according to P&I surveys and reporting.
The data show the five largest corporate pension funds using LDI are General Motors Co., International Business Machines Corp., Boeing Co., Ford Motor Co. and Verizon Communications Inc., while the largest public pension fund using the strategy is the Public School Retirement System of Missouri.
The interest rate environment in recent years has contributed to growth in pension fund liabilities as AA-rated corporate bond yields have dropped to 3.94% as of Feb. 22 from 5.78% at the beginning of 2008.
That rate environment has presented a poser for institutional investors. Given the low rates, low funded status, higher contributions and a thirst for alpha, some experts say the timing for LDI might not be good, while others say LDI is a long-term strategy, not a flavor of the month, and so anytime's a good time to jump in.
“It's a big concern out there,” said Tom McAuliffe, New York-based managing director and head of global institutional consulting at Bank of America Merrill Lynch, which manages $38 billion for defined benefit plans. “Is it the right time for LDI? Do we ride out rates now?”
“Every investor should be liability sensitive,” said Seth Masters, chief investment officer, asset allocation, at AllianceBernstein (AB) LP (AB) in New York. “The question is, who should be liability driven?”
“It's the question we live with all the time in this space,” added Andrew Johnson, Chicago-based managing director and head of LDI at Neuberger Berman Group LLC. “For many plan sponsors, it's a hard sell.”
What makes it a hard sell is that some DB plan executives still look at their strategies from a performance-centric perspective. What is driving plans to consider LDI is a change in focus to risk management, along with a look at pension funding as part of a company's overall risk strategy.
“At the end of the day, the liabilities are what drives the decision” as to whether to adopt an LDI strategy, said Gary Veerman, Chicago-based head of LDI at Legal & General Investment Management America. “How much interest rate risk and credit spread risk you want to hedge, and how much risk tolerance do you have.”
“The LDI question breaks into two pieces,” said Mark Ruloff, director of asset allocation for Towers Watson & Co., based in Arlington, Va. “What to do with your fixed-income portfolio, and do you want to increase your fixed-income portfolio? For the first part, the best way to hedge liabilities is with a fixed-income portfolio. The second part is more challenging given the current fixed-income environment.”
In an online survey conducted jointly in March 2012 by P&I and Rocaton Investment Advisors, two-thirds of DB executives said they have LDI strategies in place, with the number expected to rise to more than 80% by 2014. Also, a majority of LDI users said they would move more money to LDI strategies — and away from growth asset classes such as equities.
Goodyear rolls into LDI
One company that recently made the switch to LDI is the Goodyear Tire & Rubber Co., Akron, Ohio, which on Feb. 12 announced plans to use the strategy for its $4.1 billion in U.S. pension fund assets (P&I, Feb. 18). Darren R. Wells, Goodyear executive vice president and chief financial officer, told investors the move to “prefund” and “derisk” the plans affects the approximately $1 billion in unfunded liabilities for its U.S. salaried pension plans, which were frozen in 2008, and $1.7 billion in unfunded liabilities for its U.S. hourly pension plans, which were closed to new employees in 2009. The plans had a funding ratio of 60.7% as of Dec. 31.
It's that trend to derisking, many say, that is fueling the drive into LDI.
“If you have someone looking for an entry point, I'd tell them to stop,” said Al Pierce, managing director at SEI Investments (SEIC), Oaks, Pa. “Tell me how much risk you can take and how much you can afford. Then we can set a risk tolerance strategy. It's not just (plan) funding.
“You can either afford (LDI) or not. You can't time it.”
SEI manages $51.1 billion in LDI strategies.
At Joy Global Inc., a Milwaukee-based mining equipment manufacturer, the decision to move into LDI was made in 2010, around the same time as the decision to close and ultimately freeze its DB plans worldwide to new employees, said Barbara Bolens, vice president and treasurer. The company's CFO, Mike Olsen, who retired Feb. 1, made the decision. “He was famous for saying, "I'm very much committed to paying for our liability, but I only want to pay it once,'” Ms. Bolens said. “Matching our liabilities became a mantra for the company.”
As of Oct. 31, Joy Global's U.S. pension plans had $1.02 billion in assets and $1.2 billion in liabilities, for a funded status of 85%, Ms. Bolens said. Benefit accruals are still being made to a small portion of participants whose union contracts do not have an agreement to freeze their plan, but those parts are expected to be frozen when the contracts expire. The company's two U.K. plans have a combined £358 million ($547 million) in assets and £414 million in liabilities for a funding ratio of 86%. When LDI was implemented, the U.S. plan was 65% funded, she said; Ms. Bolens did not have the funding amount for the U.K. plans in 2010.
SEI has been Joy Global's outsourced CIO since 2000. Before going into LDI, the plans' combined asset allocation was 50% equity, 30% fixed income and 20% alternatives, including hedge funds and structured credit. As of Oct. 31, it was 80% fixed income and 20% equity. Joy Global has two LDI managers and six equity managers with separate accounts specific to the company's goals.
She called the strategy “a success. We contribute on a monthly basis and we want it to go into deficit reduction.” The company could ramp up its bond exposure to 90% or even 100% as funded status continues to improve. “We have absolutely no regrets,” Ms. Bolens said. “We really don't care that much about return; all we really care about is tracking error.”
What has made LDI work for plans is the creation of glidepaths that increase allocations to certain bond strategies based on certain triggers.
Towers Watson's Mr. Ruloff sees three such triggers: funded status, interest rates and time horizons. Milla Krasnopolsky, senior consultant and U.S. architect for dynamic derisking solutions at Mercer LLC in New York, cited two potential glidepath triggers — level of funded status and level of interest rates — where LDI investing increases in order to reduce the overall funded status volatility.
Determining the glidepath, or dynamic asset allocation strategy, takes into account myriad factors. Mr. Ruloff said Towers Watson advises its clients to create a glidepath using five tools: liability hedging, which he called the foundation of LDI; diversification among risk-return drivers; risk steering, to determine where and when to take risk; risk pricing, to buy or sell insurance based on market conditions; and what he called “long-termism,” or theme investing to take advantage of emerging markets securities, sustainable investing and natural resource strategies, among others. Of those five steps, he said risk steering is the most important. “You need to take a holistic, enterprise-wide approach,” he said.
AllianceBernstein (AB)'s Mr. Masters said that two companies with the same $100 million liability could have vastly different strategies given how large that underfunding is in relation to the size of the sponsoring company. “A $10 billion company with $5 billion in annual revenue, no way would they go about using an LDI strategy,” Mr. Masters said. “They'd be heavily into equities and then, when better funded, transfer the risk. A $1 billion company ... that liability would be a key item for them in their overall corporate strategy, and they would look more into LDI.”
In Joy Global's case, the company's market capitalization as of Oct. 31 was $7 billion with 12-month revenue of $5.5 billion, Ms. Bolens said.
Mr. Masters said that LDI is one of several strategies that can be used for managing liabilities. “There's different strategies for different people,” he said.
“It has to be customized,” said SEI's Mr. Pierce. “If the pension plan is large relative to the (sponsoring) business, highly correlated to capital markets, they can't afford to take risks. ... But for those who are comfortable with volatility with no balance sheet impact, then absolutely, they should have less LDI. Nothing wrong with that.”
“There isn't one size fits all,” said Kane Brenan, head of global portfolio solutions at Goldman Sachs Asset Management in New York. “Fundamentally LDI is a risk-management decision. In managing a plan, LDI is one component. You need to figure out where to take the risk and where to hedge the risk.”
The risk considerations also extend to closed and fully funded plans, which normally would seem the most fertile ground for LDI strategies. “Benefit accruals are still a risk, there's also actuarial risk and basis risk,” added Michael Moran, pension strategist at GSAM.
At Northern Trust Corp., Chicago, which doesn't have a specific LDI strategy, Richard Campbell, senior investment program strategist, said selection of outside managers to run a strategy that meets individual clients' needs is crucial. “While low rates continue, it's important to have a glidepath that raises both funding and duration at the same time.”
Another consideration is how much the company is contributing to the pension plan. It could be in cash, as Goodyear did with $454 million to its U.S. pension plans in 2012; in debt, as Ford Motor Co. did by selling $2 billion in 30-year notes in January, mostly to finance accelerated contributions to its worldwide DB plans this year; or stock, as AT&T Corp. announced it would do in October by seeking to contribute a $9.5 billion preferred equity interest in its wireless business to its pension plans. Joy Global plans to contribute $180 million to its worldwide pension plans in the current fiscal year, which ends Oct. 31, Ms. Bolens said.
This article originally appeared in the March 4, 2013 print issue as, "LDI bandwagon rolling on".