Chris Anast, CFA
P&I: How has LDI evolved since the financial crisis?
Chris Anast: During the financial crisis, pension plans saw a drop in funded status averaging around 30%. They raced to say, 'What can we do to prevent this from happening again?' Moving into long bonds was the easiest step plan sponsors could take to implement an LDI framework. The focus on plan objectives really has shifted over those 10 years to things like minimizing cash contributions into the plan, controlling volatility of the funded status and protection of the current status, minimizing [Pension Benefit Guaranty Corp.] premiums, and exit strategies for frozen or closed plans. LDI went from being synonymous with long-duration bond strategies to more of a framework for managing total pension risk with a focus on downside protection.
The real shift is the benchmarks that plan sponsors use. Today, the benchmark is the liability rather than public benchmarks.
P&I: Tell us more about new benchmarks and new asset classes for LDI.
Chris Anast: The benchmark isn't this policy benchmark made up of how your plan is allocated. It's your liability. So plans have turned to other asset classes like hedge funds, private equity and real estate to create a portfolio that's designed to be resilient to down markets, and we've seen broad public equity exposure over the past decade decrease as a result.
A lot of people once thought, 'Now that you adopted an LDI strategy, you must be 100% bonds,' and that's not at all what happened, and it's not the right move for the majority of plans.
P&I: What choices do plan sponsors have today when it comes to credit selection?
Chris Anast: LDI is not just about long-duration bonds, but it's certainly an important piece of that portfolio. In our experience, credit selection has consistently shown the potential to add value. In the current environment, avoiding credit downgrades should be a priority for plan sponsors.
The long-duration component of an LDI framework should be managed in a way that controls for downside risk and is understandable to a plan sponsor. Active credit research has the potential to add value while controlling for that risk. We believe that for your credit portfolios, active is the best way to go.
P&I: Is there enough liquidity in all corners of the credit market to meet any plan sponsor's LDI needs?
Chris Anast: While we do not see any immediate issues with liquidity, the potential exists with continued de-risking and new adopters of liability-driven frameworks. Keep in mind, insurance companies find long-duration bonds quite attractive as well, so the demand is not solely from the pension space. This is something we are monitoring closely.
From a pension perspective, the impact may be greatest for plan sponsors that are on the cusp of implementing a long bond portfolio and have decided to wait. That's why I say it's important to focus on the long-duration bond portfolio now.
P&I: What are the most common questions you hear from plan sponsors?
Chris Anast: Aside from 'When will rates be going up?' — which is challenging to answer — the other is, 'Why move to LDI now?'
Asset-liability connection and liability-driven investment strategies are really a measurement of health. Not moving to LDI is akin to thinking, if I have a poor diet but I don't have any significant health issues, why should I start eating healthy now?
LDI strategies really provide that nutrition plan for the health of a pension plan. Starting early and monitoring the health of your plan by implementing a strategy that will keep you on track is key, and that's why people should be adopting these strategies right now.
P&I: Walk us through a typical LDI program implementation.
Chris Anast: It should start with an asset-liability analysis, and that can be in collaboration with the actuary, consultant and/or investment manager. Analysis of the liability cash flows includes how they may be affected by a changing market environment, coupled with changes in plan assets to see how they move in tandem. That collaboration between the actuary, consultant and investment manager is very important for this analysis.
Then implementation should focus on evaluating the plan sponsor's objectives and how they define risk — do they see risk in the form of significant contributions and want to focus on minimizing or stabilizing that, or do they see it as the funded status moving lower and want to focus on maintaining the current level? Then look at the current funded status and create a hedging portfolio that best suits the liability.
You want to find that mix between hedging and return-seeking assets to have a risk level that, as a plan sponsor, you are comfortable with, given the bears lurking in the woods. Then you shift to evaluating that return-seeking portfolio for other opportunities to reduce risk.
The final thing is measurement.
P&I: What are the biggest challenges you face when implementing LDI programs and how do you overcome them?
Chris Anast: The challenge is getting plan sponsors that have waited to implement LDI to take that first step into a long-duration bond portfolio. The current low-rate environment has sponsors hesitating, but structuring a sound long bond portfolio now will lower the potential of having to deal with liquidity issues in that market after rates rise.
The second challenge I would say is clarity on exactly what they're trying to hedge. Fully customized liability benchmarks are very compelling, but they can be complicated, and they can end up with a higher degree of basis or uninvestible risks than what a plan sponsor expects.
Key to this entire concept is stressing the importance to plan sponsors of setting plan objectives and measuring them, and understanding the investment strategies that are being implemented to help them achieve those objectives while evaluating risks that their plan is going to face in different environments.
It starts with a core fixed-income portfolio that's buying duration, correlates well to the liability, can be enhanced with strong credit selection while still controlling for risk. Taking those first steps is really the key to making that pension journey successful, no matter where or when a plan sponsor plans to end that journey.