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Liability Driven Investing
P&I Custom Media Group Sponsored Round Table | October 27, 2013
Meet the Round Table Participants
Peter AustinHead of Fixed Income Solutions,
T. Rowe Price
Senior Investment Consultant,
Christopher Paolino, CFASenior Vice President
Senior Portfolio Manager,
Hartford Investment Management Company
The outlook for liability driven investing (LDI) is improving, with more than half of corporate pension plans using these strategies, and worldwide LDI assets growing. A rising rate environment may drive further adoption of LDI as plan sponsors try to lock in improvements in funding ratios—over the past year, sponsors have seen improvements not just in funded status, but also a drop in the aggregate U.S. pension deficit.
Yet, just as the newest developments in LDI can help plan sponsors address long-standing funding challenges, they may also bring challenges of their own. For example, custom benchmarks tailored to liabilities can help plans better manage surplus volatility. But such strategies require an in-depth understanding of all the dimensions of risk within the liability stream. The advent of dynamic LDI may offer sponsors more options in terms of de-risking, but it potentially raises challenges in areas like policy setting, glidepath design and governance. For example, sponsors need to be careful that glidepath triggers do not increase trading frictions to the point that they affect the plan's ability to implement its policies. And governance must be nimble enough to respond to market developments quickly and efficiently.
We asked three prominent LDI providers for an overview and analysis of the state of LDI: where it stands today, and the most important developments on the horizon. They cover a wide range of topics from asset allocation, to contribution policy, to custom performance benchmarking, to understanding the complexities of liabilities and surplus volatility. The issues are many, and often complex, but these experts help put them into perspective.
P&I: Let's start with a quick overview of funded status for pension funds, since that is a key driver of LDI adoption—what is the overall state of funding and what are some reasonable expectations over the medium term?
Milla Krasnopolsky: Funded status levels are impacted by performance of capital markets, levels of interest rates, corporate funding, and changes in expected benefits. There is significant momentum from pension funds in thinking about how and when to reduce asset risk relative to liabilities as funding levels improve. As of the end of September, the average funded status was about 91% for S&P 1500 companies up from 74% at the beginning of the year. The aggregate deficit stood at about $182 billion, which represents a significant decline from $557 billion at the beginning of the year. Although significant further increases in interest rates are not expected in the near term, we do expect rates and asset returns to further improve funding levels over the next few years. Plan sponsors have seen how quickly funded status gains can melt away during a market crisis and want to make sure that policies are in place to reduce risk either immediately or as funded status levels increase. The pace and type of derisking strategy depends on a variety of risk budgeting considerations for the plan and the plan sponsor.
P&I: So what does the improvement in funded status, and potential increase in rates mean for LDI strategies—for both providers and plan sponsors?
Chris Paolino: A lot has changed since the 2008 financial crisis in that many corporate defined benefit plans are now closed, from both the final average pay and cash balance plan standpoints. So, CFOs are very keen to ensure they lock in some of the gains in funding ratios made over the past year, and further reduce equity risks as these plans move along their glidepaths. If rates continue trending higher, the adoption will further accelerate. If rates stabilize at these levels, I think you'll see a more measured approach to LDI.
And implementation for any given sponsor will depend on where they are in the trajectory towards a more asset-liability managed portfolio. The less matched you are, the less sensitive you are to things like key rate matches and things of that order that a full immunization would address. Essentially, the first phase of the trade was to reduce equities and add to fixed income; the second phase was to extend the duration of fixed income; and now we are entering the third phase where plan sponsors are now matching liabilities with greater precision and sophistication.
Peter Austin: We expect that some sponsors will remain committed to glidepaths and de-risking programs that were instituted years ago. Others might still be cautious about the yield environment, given that the Federal Reserve's 'tapering' could result in higher volatility in the near term. As a result, while some sponsors may be committed to de-risking over the long term, right now they may be considering interim steps designed to reduce the overall volatility, but not go so far as buying long bonds at a time when one could argue there still is a bit of room for rates to rise.
An important variable here, often overlooked in discussions of LDI, is contribution policy. Funded status overall has recently improved to close to 90%, and for most sponsors that improvement came with little to no contributions. Now, within LDI strategies, changes to asset allocations can be based on changes in funded status, or changes in rates, and so forth. But contribution policy represents another key decision point in the LDI process, and sponsors need to be deliberate about how they approach this question.
Contributions are an important factor in managing funded status volatility, which is the fundamental driver of all LDI strategies. The decision whether or not to make contributions will inform the speed and stability of the path toward the plan's target outcome, in terms of funded status. Some may find it advantageous to contribute funds and accelerate their path to the desired end state. Others may let the status quo stand, and let their assets do the work to get them closer to the target funded status, without additional cash contributions. And so contribution policy becomes an important factor in building an asset-liability framework—and enabling a plan to achieve its goals within a specified timeframe.
P&I: As demand for LDI strategies has grown, how has it evolved—what are some of the more important developments over the past few years?
Peter Austin: One area of innovation is defining performance by custom benchmarks that are reflective of a plan's liabilities and the characteristics of those liabilities, rather than using traditional benchmarks like long government or long credit. Custom benchmarks allow fixed income managers the opportunity to manage specifically against those liability characteristics from a duration standpoint, where at the end of the day the performance of the fixed income strategy is designed to meet or perhaps in some cases exceed the performance of the liabilities.
Plan sponsors recognize that they could have positive performance in asset returns and still lose ground in funded status if their liability returns are higher than asset returns. Depending upon the structure of a strategic asset allocation, asset performance may not be highly correlated to liabilities, especially if the portfolio holds a lot of equities. So we are seeing continued evolution in performance benchmarking, particularly in fixed income mandates, and I think we will see more of that in 2014 as sponsors' fixed income mandates begin to reflect their improved funding levels—both for new mandates and continuations of existing de-risking programs.
Chris Paolino: Another part of the LDI trend has been an increasing use of alternatives, with a goal of achieving meaningful reductions in funded status volatility. Generally speaking, most sponsors view alternatives comparable to public equities from an expected return perspective, and in some cases even superior to public equities, depending on the type of alternative investment. But the observed volatility of alternatives is different, or muted, and they may deliver an uncorrelated return stream that further diversifies the portfolio's traditional asset mix.
When viewed through the lens of minimizing funded status volatility, if we were to rewind to six or seven years ago, the major driver of funded status volatility would have been the equity allocation in most plans. That has been reduced over time, and in some cases replaced with alternatives that are either less volatile or uncorrelated to the other risks in the portfolio—complemented by adding to fixed income allocations and extending duration. So the main benefit that plan sponsors see in alternatives today, in the context of LDI, is reducing the impact of equity volatility on funded status.
Milla Krasnopolsky: LDI strategies in general are becoming more sophisticated. Plan sponsors are focusing more on funded status growth and risk management, as opposed to traditional portfolio management tracked against market benchmarks. We are seeing a higher acceptance of dynamic LDI strategies, including option based strategies and incorporation of alternative glidepath triggers. LDI is no longer viewed just in terms of managing duration risk to the liabilities and as an isolated strategy, but more as an integrated way of managing a pension plan by taking into account different risk exposures from both assets and liabilities. This integrated approach is generating changes not just to investment strategies but also to performance reporting, risk monitoring and governance.
P&I: How are plan sponsors addressing the governance challenge raised by dynamic LDI strategies?
Milla Krasnopolsky: To solve the governance challenges, plan sponsors are including a variety of de-risking or hedging triggers in their strategic asset allocation policies, in order to establish a more transparent and nimble execution process. Traditionally investment policy statements were broadly defined, but are now being developed with much more specificity regarding the implementation of LDI and de-risking solutions. Given the intensive nature of some of these dynamic LDI strategies—i.e., reporting and risk management requirements—some sponsors that may be resource constrained are thinking about outsourcing LDI management to strategic partners who can understand different aspects of the pension management process, diverse liability structures and their associated risks, and be able to implement a wide range of LDI solutions.
Overall, LDI implementation is ever-evolving because, as plan sponsors focus more on risks relative to liabilities, it changes how pensions are managed throughout the process, from strategy setting to implementation to monitoring. As far as outsourcing is concerned, there is growing demand for strategic partners who can be involved at all points in the pension management process, understand different liability structures and associated risks, and be able to implement a wide range of LDI solutions.
P&I: Given the potential challenges, how integral are dynamic strategies to the success LDI programs?
Peter Austin: That question gets back to a fundamental issue of LDI as an investment framework, for articulating at a plan level the willingness, and ability to assume risk, which for most plans is funded status volatility. What has been a refreshing, and a very positive trend in the last five years, is an increased awareness about the real risks that exist within pension plans. And now with the recovery in funded status, sponsors can focus their attention on what is most important: clearly articulating how they would like their asset allocation to respond to different environments.
Chris Paolino: Philosophically, it's very important for plan sponsors to have a dynamic allocation framework or glidepath that is embedded into the investment policy statement. The investment staff and outside managers need to have the latitude to respond to changing market conditions. In a very volatile interest rate regime, the ability to be nimble through the investment policy statement is critical.
Gone are the days where you had several months lead time to change your policy statement and asset allocation. Having a glidepath that is set out dispassionately—while everyone is level-headed—takes some of the emotion out of the committee process in situations where markets seem overly volatile. As an example, we saw a very sharp back-up in interest rates in the third quarter of 2013. What does one do in that environment? Having a plan that is agreed to in advance is a critical aspect of getting the program implemented.
P&I: Just how “dynamic” does dynamic LDI need to be, and what does dynamic implementation look like?
Chris Paolino: It can be done multiple ways, such as through triggers that change target asset allocation as a result of changes in funded status, or triggers that might change target allocations as a result of overall levels of interest rates. Different committees have different comfort levels with each of those metrics, and both are appropriate as long as you have set out your risk-return tolerance in advance. Everybody needs to be on the same page as to what those triggers are, and how drastic the resulting changes in asset allocation will be.
Milla Krasnopolsky: Dynamic implementation may be governed by a predetermined glidepath policy, a more general risk budget for the different levels of risk that the sponsor is willing to take, including market related risks and tactical or alpha risks, or a combination of both. To the extent there is a de-risking glidepath or dynamic hedging strategy in place, the investment policy needs to reflect the methodology of determining any trigger points. Once the policy is in place, the next step is to ensure that the necessary systems and infrastructure are in place to execute the policy in a nimble and flexible way – nimble in terms of speed of execution and flexible in terms of ability to take advantage of different instruments and strategies that allow for most cost effective risk reduction.
Adjusting asset allocation based on level of funded status is one way to implement a dynamic strategy, but there are other types of risk factors that may also drive changes in allocation. A dynamic investment policy needs to take all these risks into consideration as assets and liabilities change. For example, do funded status changes arise from plan asset performance, changes in the liabilities, or from contributions? The driver for the change in performance is important because that will influence how the dynamic strategy may be implemented.
P&I: What other kinds of implementation challenges need to be addressed with dynamic LDI strategies?
Peter Austin: One important factor is trading cost. For example, I have seen glidepaths that shift allocations for every percentage change in funded status. Quite frankly, if you tried to employ a strategy like that, you would likely have significant frictional costs in terms of trading expense. So, ensuring that your program is one that can be efficiently implemented is important.
I also believe that opportunity cost is a metric that more plans need to consider. It gets back to the question of how does one help inform the decisions of investment committees and other fiduciaries? Utilizing a range of analyses, including deterministic scenario-based analysis, can help frame the potential cost of decisions. Say, for example, you decide not to shift from equities to fixed income because you are concerned about what the Federal Reserve might be doing, but then equity markets sell off. You need to understand what retaining that exposure to equities—which would otherwise have moved to fixed income—could cost you. At the same time, you need to understand the impact of higher rates and the potential benefits that would accrue to you if equity markets remain static and rates rise.
Cost has many dimensions, and being able to frame the cost/benefit relationship across a wide range of
decisions is critical to designing an appropriate LDI strategy.
Chris Paolino: When considering trading frictions one also needs to recognize that the plan sponsor community at large has established glidepath yield triggers, and sponsors and investment managers need to be wary of where those yield points are—points where plan sponsor triggers will prescribe particular trades.
As for overall implementation costs, ALM implementation should be relatively efficient. The bigger issue is opportunity cost, which is the return potential you give up by moving out of risk assets and into fixed income assets at this point in the cycle. That issue needs to be framed with an eye toward plan objectives. The fact is that most plans, to the extent that they are overfunded, cannot withdraw capital from the plan. So the issue is not so much return maximization as it is about reaching the plan's objectives and accommodating the risk tolerance of the sponsor.
Milla Krasnopolsky: Some of the implementation challenges are related to the asymmetric characteristics of funded status risk and overall levels of risk tolerance. For pension plans, in general and specifically for frozen plans as they become better funded, the cost benefit analysis is becoming more asymmetric. What I mean by that is, beyond a certain point of funded ratio or surplus, the plan could invest all assets into a risk-free treasury strategy or take on minimal amounts of investment risk. So one choice is to wait and continue to be exposed to asset and funded status risk until such time when the desired surplus level is achieved, or alternatively to monetize potential future excess surplus as funded status gradually improves, in exchange for funded status downside protection. The asymmetric funded status risk tolerance – unnecessary surplus beyond a certain point, but a low risk tolerance for significant funded status declines - provides a foundation for dynamic de-risking strategies.
P&I: So, what is today's best thinking on how to measure risk and return, and benchmark the overall success of LDI strategies?
Milla Krasnopolsky: There are multiple definitions of risk and they vary based on the key plan objectives. However, regardless of what the risk metric is, risk measurement is only useful to the extent that a plan sponsor has the ability to manage that risk. So there has to be a way to make the risk management process actionable. One way to do that is to create policies that are risk-based as opposed to capital-based. Many rebalancing or de-risking triggers are based on capital allocations relative to target investment policies. However if policies focus on risk targets, such as level of duration or equity beta, in addition to capital allocations, then managing funded status risk may be managed more efficiently as systemic market risk exposures are aggregated across all assets and liabilities.
Regarding performance benchmarking, the overall plan benchmark should be the liability together with a process for measuring and monitoring contributors to funded status change. However, there are various complexities to modeling liabilities. Although most LDI managers mainly focus on a point in time projected cashflow durations in determining the appropriate liability hedging strategy, assuming that a liability would perform just like a zero coupon fixed income instrument is an oversimplification for plans with more complicated liability structures that include variable benefit provisions or varying degrees of optionality. Another factor that affects how liability risk is measured is the type and magnitude of credit risk that is embedded in the discount rate calculation. Taking all these factors into account, it is then not surprising that performance of customized liability benchmarks may vary greatly from one plan to the next and standard peer universe comparisons become challenging and possibly irrelevant.
Funded status performance and risk reporting that reflects an integrated asset and liability investment and risk management process demonstrate the ultimate measures of success for an LDI strategy.
Chris Paolino: The first step to effective risk measurement is to adapt the framework so that it incorporates liabilities and looks at risk based on those parameters. One of the key things for both staff and investment committees to understand is this: If your funded status volatility is something you are specifically trying to minimize, what are the main drivers of that volatility? Is it equity risk? Is it interest rate mismatch? Is it lack of corporate spread duration risk? All of those things are factors that people need to be aware of as they move down the path. There are lot of different ways to model and test for those risk factors, and lots of different risk statistics that you can consider. I think that there are advantages and disadvantages to all of them. The key is to understand your main drivers of risk and your tolerance around that volatility.
We also feel strongly that the higher a plan allocation to fixed income, the more important it is to have a custom benchmark. The liability stream can change a lot, particularly if there are nuances—for example, a high proportion of the liability being in a cash balance plan that has floating rate dynamics, or minimum guarantees. So as you get further down the path toward immunization, the more important it is to measure performance against a nuanced benchmark.
Peter Austin: There is no one answer for how one defines, manages and monitors the risk of a pension plan, because the risk can take different forms. You need a collection of different measures to help develop a rounded view of the risk attributes of a plan so that the fiduciary, together with its advisors, can make informed decisions.
The way we think about pension plan risk is the volatility of funded status, which incorporates asset allocation as well as the funding levels of the plan. Every CFO, particularly CFOs of public companies, is acutely aware of funded status volatility because it impacts balance sheets, and a wide range of other issues, not the least of which is access to liquidity. Metrics like value at risk (VAR) are interesting, and looking at VAR from a probabilistic standpoint can also be helpful. There are no right or wrong answers. It all depends on the environment and the objectives of the sponsor.
What plan sponsors need is a decision framework that is consistent over time, and given the volatility of today's markets, the importance of consistency cannot be overstated. The decision framework gives you an opportunity to consider all of the potential outcomes, which will better prepare the sponsor to accept whatever outcome transpires. Plan sponsors are making decisions everyday with regard to their plans. It is critical that they are not surprised by the outcomes, so they can stick with the de-risking plan they have laid out.
This sponsored round table is published by the P&I Custom Media Group, a division of Pensions & Investments. The content was not written by the editors of the newspaper, Pensions & Investments, and does not represent the views of the publication, or its parent company, Crain Communications.