Fixed income: Not stodgy anymore

Money managers are bracing for an expected surge in demand for liability-led investment strategies.

European pension funds are signing on in growing numbers for the investment strategies. U.S. defined benefit plan sponsors — despite their growing frustration in dealing with huge swings in funding levels and volatile contributions — for the most part have yet to jump on that bandwagon.

But money managers that provide liability-led investment products are keeping a close eye on changes in the U.K., in anticipation that similar regulations will be imposed in the United States in the next year or two. Earlier this year, the International Accounting Standards Board, London, amended its Rule 19, which effectively banned the practice of actuarial smoothing — deferring gains and losses from one year to the next — by European pension plans. Additionally, the Pension Protection Fund, also in London, imposed risk-based premiums on U.K.-based pension funds. Such a rule could make maintaining a plan more expensive.

Roger Urwin, global head of the investment consulting practice at Watson Wyatt Worldwide LLC, Reigate, England, said liability-driven investing has developed quickly in Europe in response to the new rules. "Most of the growth … has come from pension funds identifying some of their liabilities and creating a matching investment portfolio, typically through using swaps and pooling vehicles."

Barclays Global Investors, San Francisco, is among those with new liability-driven investment funds for European clients, said Matthew Tucker, managing director and head of advanced fixed-income strategies. BGI recently launched a suite of 16 sterling- and euro-denominated funds. Clients can buy shares of the funds and, in exchange, BGI provides inflation and interest rate protection that matches the clients' liability streams. To date, the strategy has garnered £16 billion ($19.5 billion) in assets.

He wouldn't say when a similar strategy would be available here, but added: "We're always looking at new products to introduce in the U.S., and the liability-driven investment pool is one of them."

UBS Global Asset Management, Chicago, created a global asset allocation solutions group to work with domestic and international clients on aligning assets and liabilities, said Drew Carrington, executive director and senior U.S. fixed-income portfolio manager. "The U.K. is a great example of a lot of clients first extending duration," he said. "We are looking at some interesting strategies, one of which targets LIBOR or the Consumer Price Index plus some extra return."

Margo Cook, managing director, institutional fixed-income management at BNY Asset Management, New York, said the firm has done some work in liability-led strategies for clients she wouldn't name. "A client came to us recently and had us implement a strategy where 80% of the bond portfolio is tied to the Lehman Aggregate bond index, and 20% is tied to bonds with durations of 20 or more years. That's been a huge winner for us. Other clients have asked us to manage money in the intermediate-duration space in order to match part of their liabilities," Ms. Cook said.

Ryan ALM Inc., New York, has found success offering its portable alpha liability strategy. The firm will match a client's liabilities in a beta portfolio through the use of derivatives, while the alpha-generating portfolio adds incremental layers of returns on top of liabilities. "In the PALS strategy, bonds are used to match liabilities, and some non-fixed income strategy, such as an equity portfolio, is used to add returns on top of them." said Ron Ryan, president and founder of Ryan ALM. He said the firm has garnered a little more than $1 billion for the strategy during the past year or so.

Russell Kamp, managing director and head of the INVESCO structured products group, New York, said he has been talking to clients about a portable alpha product, similar to Ryan ALM's PALS, that uses derivatives to gain exposure to a basket of bonds whose durations match the liabilities of a client, and gains incremental returns in an alpha-generating, non-bond portfolio. "So far, interest has been extremely light, but there has been a lot of discussion on it," he said.

Among the European plans that have implemented liability-led investing strategies are Dutch giants the €157 billion ($202.9 billion) Stichting Pensioenfonds ABP, Heerlen; the €60 billion Stichting Pensioenfonds PGGM, Zeist; the €4.2 billion Hoogovens plan, Ijmuiden; and the €3.4 billion Stichting Pensioenfonds Akzo Nobel, Arnhem (Pensions & Investments, May 21).

One U.S. company looking at such strategies is International Paper Co., Stamford, Conn. IP executives are considering a swap overlay program to synthetically increase the duration of the bond portion of the $6.5 billion defined benefit plan.

"We've presented it to the board for approval, and we haven't gotten permission yet … Basically, we're looking at a swap overlay program that would synthetically increase the duration of our bond portfolio. With the way the equity markets are going, it's the prudent thing to do," said Robert Hunkeler, senior vice president of investments. He said IP executives are working with NISA Investment Advisors, St. Louis, on developing such a strategy.

So why haven't most U.S. pension plans — of which the 100 largest are underfunded by a total of $69.5 billion — implemented a liability-led investment strategy that aligns their assets to their liabilities? Industry executives point to a few things:

c Potential regulatory changes. Most money management executives and plan sponsors expect a change in the way the actuarial discount rate can be calculated by the federal government. Additionally, most industry experts expect the FASB to alter Statement 87, which allows for actuarial smoothing, by imposing some form of a mark-to-market accounting standard. Finally, most expect the Pensions Benefit Guaranty Corp. will impose risk-based premiums that would be based on the funding level of a corporation's pension plan.

c Low interest rates. The federal funds rate was at 3.25% and the yield of the benchmark 10-year Treasury bond was around 4% as of Aug. 1. Under today's accounting rules, pension fund liabilities move the opposite direction of interest rates. Therefore, lower interest rates mean higher liabilities.

c A lack of supply of long-duration bonds. In a liability-led investment strategy, a pension plan would typically seek bonds whose durations match or exceed the plan's projected liabilities. But with liabilities usually projected over 10 to 15 years, only $1 trillion in available bonds with durations beyond 10 years and total U.S. pension assets around $10 trillion, there would not be enough supply of long-duration bonds to meet that demand if every pension plan decided to implement a strategy that aligned assets to liabilities.

"The key problem right now (is) the current accounting and actuarial rules. That is the major villain of our story," said Ryan ALM's Mr. Ryan. "We're waiting to see what will happen in the next year or two. But right now, with things like actuarial smoothing in place, corporations are essentially allowed to lie on their balance sheets. Imagine if a public company was allowed to report its earnings only once a year, and lie about it at that? That's essentially the situation we have right now with corporate pension plans."

Gordon Latter, senior vice president and head of the pensions and endowments research group at Merrill Lynch & Co., New York, said low interest rates have prevented many institutional investors from pulling the trigger on liability-led investing. "Rates have gone down, so people are just sitting on the fence right now," he said. "Plan sponsors are reluctant to lock in deficits and long-term costs by moving entirely to a long-duration bond portfolio. By mitigating interest rate risk through an interest-rate swap overlay strategy, a plan can alleviate some of these concerns."

Last February, Mr. Latter's group found that a pension plan with a 70/30 allocation to equities and debt using an interest-rate swap overlay strategy would have improved its asset-liability ratio in every rolling 10-year period since 1975 (Pensions & Investments, Feb. 21). General Motors Corp., Detroit, already has implemented such a swap overlay program for its $86 billion defined benefit plan to extend the duration of its $34 billion fixed-income portfolio to better align assets to liabilities, said one source familiar with the company. Jerry Dubrowski, GM spokesman, did not return calls by press time.

"A lot of institutional investors are seeing whether rates will rise," added James Morris, senior vice president and director of the Retirement Solutions Group at SEI Investments, Oaks, Pa. "But how long can they tolerate underfunding levels as they wait for rates to go up? They were worrying about rates in 2001, and here we are in 2005."