Liability-driven investing, or LDI, is not strictly defined with rigor, and that has led to some confusion in the marketplace, said François Pellerin, Multi-Asset Class Strategist at Fidelity Investments. Speaking at Pensions & Investments’ Canadian Pension Risk Strategies virtual event, he favors a simple, textual definition: “LDI means that you invest in a way that's cognizant of what you're trying to beat or to cover, which is a liability, as opposed to a fixed benchmark bogey.” Looking at it in this context, there’s a distinction between LDI and investing in long bonds, Pellerin pointed out. My analogy is that “LDI is a toolbox in the pension risk management garage. In that toolbox, you have long bonds and many other tools,” he said, at the session titled ‘LDI in an ever-changing world: New LDI techniques in a non-solvency world.’
LDI IS A TOOLBOX IN THE PENSION RISK MANAGEMENT GARAGE
With that definition, the next question is, "What is the real value of a liability?" If you look at it in a practical way, the price of anything or the value of anything is what you can sell it for or buy it for, Pellerin said. “Think about a car, a stock, or anything else. Look at what it costs, and that's going to be the truest value you can find. For a pension plan sponsors, the cost of a liability transfer is one of the best proxies available,” he said. “With that in mind, long bonds become very relevant because what drives the price of a pension risk transfer is the mark-to-market state of high-quality long bonds.”
When a Canadian pension plan is valued under solvency rules, there’s a virtuous link that aligns towards long-duration fixed income because in that case, all relevant liabilities or risks are driven by high-quality long yields, Pellerin said. When you look at a going concern valuation that presumes the plan will continue to operate forever, that valuation method decouples the link between the liability and its actual value.
Yet it’s still relevant for the going concern plan to have long bonds for three reasons, Pellerin noted. First, the reality of accounting and termination risks still exist; second, most going concern rules ultimately converge towards mark-to-market in some form and long bonds pre-emptively address that; and third, and most important, is that regardless of going concern or solvency, the fundamental principle of asymmetry of surplus exists. For example, once a frozen plan is fully funded, equity risk should generally not be undertaken because the extra benefit from surplus “gravy” that is not as compensated as a plan deficit is painful, he explained. “At that point, long bonds are the effective way to lock-in that favorable position and never have to contribute anymore.”
Does LDI apply when the only thing you’re concerned about is the going concern basis? Fixed income can provide liquidity and it can help with active management in the overall portfolio, Pellerin noted, adding that when you have shorter bonds, it can be easier to calibrate the risk-on, risk-off components of your portfolio. LDI can also take another dimension if the plan is more focused on beating a bogey by adding alternate assets classes which are more return seeking versus hedging in nature. These can be alternative investments such as private equity, hedge funds distressed debt, as well as other asset types like global low volatility equity, high-yield, and emerging market debt, he said.
The question of low interest rates has been around for over 20 years, because that’s how long rates have been going down in North America, said Pellerin, noting that very often, he hears the undertone from sponsors that rates are ‘too low’ or ‘artificially low,’ but says that’s not necessarily the case. “For pension plans, 80%, 90% of the duration risk comes from long rates. And those rates are nebulous in the way they come about as they are driven by a mix of fundamental and technical determinants,” he said. “From a technical standpoint for example, we observe that when low yields go higher, lower liabilities improve funded ratios, and demand for long bonds increases. That puts a damper at the long end, and we've seen that time and time again in the last 10 years.”
“Fundamentally, we think that interest-rate risk is not compensated. And if a risk is not compensated, you try to ensure against it as much as possible to spend your risk budget where it is compensated. That's equity if you are a long-term investor. With that in mind, I don't think sponsors should necessarily lower their plans’ hedging portfolios at this point,” Pellerin said.
“Lastly, and this is a more actuarial view, and forgive me as I’m an actuary, but sponsors tend to look at rates as the silver bullet and say, ‘What if rates go up more than 2%? It's going to be great.’ Suffice it to project funded ratios three to five years to realize that liabilities truly are like bonds. They pull to par. Ultimately, they'll get back to their value,” Pellerin said. “Why is that? If your discount rate goes up, your hurdle rate also goes up and your assets will need to return more to be able to keep up. So, it's a bit of an artificial win in hoping that rates will go up to help your situation. Besides, hope is not a strategy last time I checked.” The current low rate environment, though not that low in Canada compared to other countries, might be the new normal for investors and they should position their LDI strategy irrespective of where rates could end up, he said.
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