Updated with correction
It's one thing to do liability-driven investing. It's another thing to measure its success.
Unlike traditional performance-based indexes and benchmarks, LDI requires a different approach, since the strategy's goal is to cover a defined benefit plan's liabilities — which requires a benchmark that shows how well a pension fund is moving towards that goal
“LDI managers don't typically benchmark against pension liabilities,” said Al Pierce, managing director at SEI Investments, Oaks, Pa. “The biggest challenge is that portfolio managers want to manage money to generate alpha based on performance against public market benchmarks. Benchmarking is the bogeyman in all of this.”
What makes it difficult is that a creating a liability benchmark often requires input from a pension plan's actuary, its money managers and the pension fund itself. That unique benchmark is what is used to help form a pension fund's individual glidepath for LDI and to measure the success of that glidepath.
“Investors typically measure investment performance against market benchmarks, but this doesn't tell the whole story of the pension plan,” said David Wilson, managing director for customized strategies at Cutwater Asset Management, Armonk, N.Y. “Beating a market benchmark doesn't mean you're managing an effective LDI program.”
He described three approaches to LDI benchmarking that are using a single market benchmark, a blend of market benchmarks, or “semi-custom approach,” that approximates a plan's liabilities, or a truly custom-ized benchmark that seeks to replicate the characteristics of the liabilities. “That (last one) is very hard to do and is resource intensive,” he said.
Whatever benchmark is selected or derived also has to be investible, said Sean McShea, president of LDI manager Ryan Labs Inc, New York, which customizes its LDI benchmark for each client. “Each client is different,” he said. “Some have more conviction in terms of hedging out risk. It all depends on a plan sponsor's education, background, and especially its overall balance sheet. Does the plan sponsor's balance sheet have the risk capacity to handle pension liabilities? That's question No. 1.”
“An actuary puts together the service costs, longevity estimates, potential inflation estimates, among other items, to create liability cash flows,” said Kane Brenan, head of global portfolio solutions at Goldman Sachs Asset Management in New York. “Then it goes to the fixed-income manager, who works them into bonds to attempt to match those cash flows. A lot depends on how closely they match it, how much wiggle room there is.”
Russell Investments and Barclays PLC in May launched a series of benchmarks, the Barclays-Russell LDI index series, which offer target durations at two-year intervals between six and 16 years to achieve tracking error reductions of between 20% and 50% in matching a pension fund's liabilities. “These indexes will behave more like liabilities will behave than any traditional bond index,” said Bob Collie, client research strategies, Americas institutional, at Russell, based in Seattle. He called the series a “hybrid” between what's available in the market and a full custom benchmark.
The Russell-Barclays series is simpler and easier for pension funds to use, and more transparent since public market indexes are used, Mr. Collie said. “You can mix them in a way that comes really, really close to the plan's liabilities in question.”
Some LDI strategies go for other investment instruments instead of just fixed income, like derivatives, said Tom McAuliffe, New York-based managing director and head of global investment consulting at Bank of America Merrill Lynch. “The whole emphasis is to replicate liabilities,” he said. Still, the benchmarks used focus more on the corporate bond market, he said.
At Neuberger Berman Group LLC, benchmark creation is a hybrid process, involving published performance benchmarks “that look like liabilities,” said Andrew Johnson, Chicago-based managing director and head of LDI. “We use off-the-shelf benchmarks paired to performance and outcome — performance only in that it absolutely mirrors liabilities,” Mr. Johnson said. “Then we use that to manage the pension liabilities.”
One driving force behind how benchmarks are made concerns what role the benchmark creator plays for the pension fund. In the case of BofA Merrill Lynch and Goldman Sachs, they serve as outsourced CIO to plan clients, which gives the firms the ability to conduct more dynamic asset allocation, while Neuberger Berman is a third-party investment provider.
At Ryan Labs, Mr. McShea said the process is not one in which the benchmark is created after the asset allocation. Instead, the asset allocation follows the creation of the benchmark. n