Many pension funds are implementing their liability-driven investment strategies the old-fashioned way.
Executives at three of the largest LDI managers BlackRock, PIMCO and Goldman Sachs each said their clients are keeping it simple: investing more heavily in long-duration fixed income to match assets and liabilities more closely, rather than applying overlays.
They said that the potentially high and unknown cost of collateral is the main deterrent their clients cite to using overlays. Those clients prefer to make direct investments in fixed income, with perhaps a small unleveraged investment in Treasury futures to avoid the unknown cost that comes with the overlay strategy.
Goldman Sachs Asset Management and BlackRock Inc., both of New York, manage $18 billion and $35 billion in LDI assets, respectively. Executives at both of those firms said only 25% of their LDI clients use an overlay strategy. At Pacific Investment Management Co., Newport Beach, Calif., only 15% use overlays. PIMCO manages $42 billion in LDI strategies.
Some management firms and pension funds prefer using an overlay with LDI.
The Clifton Group, Edina, Minn., has $2 billion in assets under management in LDI strategies. Overlay strategies are used for all of those clients. The advantage is it frees up capital to do other things in your portfolio, said Thomas Lee, a senior portfolio manager and principal at the firm.
Consultants have noted an increase in management firms offering LDI through the use of overlay strategies. Marko Komarynsky, head of fixed-income manager research at Watson Wyatt Investment Consultings Chicago office, said that six to 10 core-plus fixed-income managers have introduced LDI offerings through the use of overlay strategies in the past year.
A lot of managers who havent done LDI are using an overlay approach, Mr. Komarynsky said. Its an easier transition. They dont have to come up with a long-bond strategy.
Half and half
Roughly half of Watson Wyatt clients use overlays for LDI, while the other half implement LDI by moving more assets into fixed income or into longer duration fixed income to match assets and liabilities. The consulting firm does not recommend one type of LDI strategy over the other, Mr. Komarynsky said.
When using an overlay strategy for LDI, a client generally uses swaps or derivatives to leverage the portfolio and extend its duration. to extend the duration of their portfolio.
Using an overlay strategy has a cost, however. The pension fund must post collateral for interest rate swaps. Many pension funds post a small amount at the beginning, then agree to post more collateral on the swap if interest rates increase. If interest rates decrease, the counterparty the fund negotiated the swap with pays collateral to the pension fund.
Many pension funds are not familiar with using derivatives or the collateral issues that come with them, said Chris Sullivan, managing director and co-head of fixed income for Goldman Sachs Asset Management.
Those pension funds often approach LDI providers with the vision of using an overlay strategy, then decide to make direct investments in fixed income instead after they find out how much collateral could cost the plan.
Collateral issues are probably some of the least understood issues by plan sponsors, Mr. Sullivan said.
Making estimates on how much collateral a plan will pay is difficult since each pension plan is different, but Mr. Sullivan said a pension fund with $2 billion in liabilities, and a 12½-year duration on those liabilities, using floating swaps would have to post initial margin requirement of $30 million up front. If interest rates then rise by 50 basis points, Mr. Sullivan said the pension fund would have to post an additional $125 million in collateral. If rates increase by 100 basis points, the fund must post $250 million.
BlackRock, PIMCO and Goldman executives all said they are not opposed to using an overlay for LDI if that is what the client prefers. Its fine if you want to do it, but be prepared to write a check off to meet these margin requirements and know that you have to write it off pretty quick, Mr. Sullivan said.
Indeed, some executives expect the number of funds using overlays to increase. The argument for overlay is that you can invest in a broad range of securities and use the overlay to get the overall duration you want, explains Edward Ng, a managing director at BlackRock. If the yield curve is flat, the opportunities provided by trading across the yield curve are more muted. When the yield curve slopes up more, he predicts more people will choose to use an overlay strategy so they can invest across that opportunity set.
Cliftons Mr. Lee points out that depending on the credit of the company sponsoring the defined benefit plan, the plan sponsor can often negotiate with the investment bank providing the swap so that the fund does not have to pay collateral right away. However, that isnt without risk, he warned.
SEI Investments, Oaks, Pa., also uses overlay strategies for nearly all of its LDI clients. The firm works hard to negotiate with investment banks so that clients can use different assets in their portfolio as collateral instead of putting up cash.
When considering the use of an overlay or direct investments into fixed income for LDI, a pension fund should consider who is recommending direct investments instead of the overlay, said Jim Morris, senior vice president, global institutional solutions at SEI. Of course a fixed income manager is going to want clients in an account where they can charge a fee, he said.