LDI still winning strategy for U.S. corporate plans

Liability-driven investing, long a winning strategy for U.S. corporate defined benefit plans, will remain one going forward. But amid aggressive rate hikes this year to quell inflationary pressures, "winning" will have to be defined more narrowly, market veterans say.

For the past 15 years or so, LDI has delivered on its central aim of maintaining the funded status of corporate DB plans through periods of extreme volatility, with the added charm of providing stellar investment returns as long bond yields declined steadily over that period.

"Clients that went into LDI pre-global financial crisis … beat the crap out of their peers and the same thing happened with COVID," said Rich Nuzum, the long-time Mercer executive named the firm's executive director of investments and global chief investment strategist in August.

Mercer's status as an early backer of LDI is one reason the firm's consulting and outsourced chief investment officer businesses succeeded in picking up mar- ket share over the years, Mr. Nuzum said.

As of the end of 2021, LDI mandates accounted for $255.4 billion, or 61.5% of Mercer's outsourced CIO business, up 37% from the year before, when LDI mandates accounted for 52.3% of total OCIO assets. For Mercer's consulting business, Mr. Nuzum said the vast majority of the firm's DB clients - accounting for just under 30% of Mercer's clients and 17.5% of its assets under consultation - employ LDI.

This year, however, LDI is proving to be a more nuanced proposition.

While the strategy has continued to stabilize the funded status of DB plans — with several reports putting average funding ratios of corporate plans at 95% to 100% as of Sept. 30 — "if you pay any attention at all to your absolute returns, this year has been a horrible ride," Mr. Nuzum said. Some plans have experienced declines of 40% or more, he added.

That has resulted in a behavioral finance test, with veteran investment committee members who got through periods of gut-wrenching market volatility such as the global financial crisis and the COVID-19 sell-off with the help of LDI programs remaining "married to the strategy." Newcomers to investment committees, by contrast, are often more skeptical, he said.

For those newer investment committee members, often "every fiber of their being is screaming 'you don't hold long bonds when interest rates are going to rise, you don't hold long bonds when inflation is out of control,'" Mr. Nuzum said.

Over the past month or so meanwhile, the margin call challenges facing highly leveraged U.K. corporate LDI programs — after the surprise Sept. 23 announcement of an aggressive fiscal stimulus plan sent U.K. rates surging — have prompted a further review by U.S. plan overseers of their LDI arrangements.

In the U.S., "I expect clients and consultants will focus on two areas of change to help protect against issues witnessed in the U.K." — how much leverage plans allow themselves to use and the type of collateral they deploy to offset derivative exposure, said Gene Tannuzzo, Minneapolis-based global head of fixed income at Columbia Threadneedle Investments.

On the question of leverage, U.S. plans for the most part are already on less precarious ground than their U.K. counterparts, market veterans say.

With the three to four times leverage U.K. plans often employ for their LDI plans, "sharp drops in prices can create a liquidity issue, as they're required to post margin very quickly as prices drop," Mr. Tannuzzo said.

For Columbia Threadneedle's LDI clients, by contrast, "we see lower leverage use … most of our U.S. clients do not use any leverage at all," he said. Columbia Threadneedle does not disclose its LDI assets under management.

Meanwhile, the market mechanisms employed by U.S. corporate plans leave them less exposed to disruptive margin calls, asset owners contend.

Some U.S. plans with LDI programs get interest rate exposure via swaps and futures, so they're not immune to getting margin calls on days where interest rates go up, noted Charles Van Vleet, assistant treasurer and chief investment officer of Providence, R.I.-based Textron Inc.'s $7.7 billion DB plan.

"In the U.S., however, swaps are uncleared, which means they can post can (other) collateral instead of cash" and that, on balance, means that U.S. plans are not at risk of a cash squeeze for margin calls, Mr. Van Vleet said in an email. Textron employs an LDI strategy.

On balance, market veterans predict LDI will come through this year's period of enhanced scrutiny with flying colors, even if effort will be required to refocus attention on the primary goal of the strategy.

"If your investment objective is funded status, you're going to stick with your LDI strategy," even if a drumbeat this year saying the world is coming to an end sustains lingering interest here or there in going to cash, Mr. Nuzum said.

For any plan that does opt to back away from liability-matching long bonds in favor of shorter-term paper that would prove less vulnerable to rising yields, "you better pray rates go up because if they don't you're not going to have the money to pay your participants," he said.

"While the absolute returns this year have been a shock to some new committee members … once they understand that funded status has actually improved (since target hedging ratios have generally been below 1), (they're) generally able to get comfortable with continued use of LDI, as opposed to making what is effectively a tactical market call by shortening their fixed-income duration," he said.

Companies will likely continue to employ LDI "because accounting rules strongly encourage its adoption," agreed Michael A. Rosen, principal and CIO of Santa Monia, Calif.-based Angeles Investment Advisors LLC.

For LDI, the driving force for utilizing the strategy is Financial Accounting Standards Board rules under which asset-liability mismatches flow down to a company's income statements, he noted. The fact that that's not the case under Governmental Accounting Standards Board rules explains why public pension funds don't adopt LDI, he said.