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If adding complexity and getting buy-in from your board to explicitly lock your fund into a glide path is LDI 2.0, how to rebalance within that glide path—with its mixture of liability hedges, swaps, and duration issues—is very much LDI 3.0. Like many a new technology, questions are arising about just how much thought has gone into this third-generation model.
Retired IBM Retirement Funds head Jay Vivian agrees that board buy-in is an important issue, but worries that the complicated interplay of swaps, bonds, interest rates, and liabilities has been intellectually neglected. “Suppose you have $1 billion in liabilities with duration 12, $600 million in stocks and $400 million in 10-year duration bonds, and a $200 million notional 20-year interest-rate swap,” he says by way of example. “The fact that you have the swap, and that you've pushed your bond duration out to 10, demonstrates your and your board's awareness of the desirability of LDI. You're 100% funded, and your assets provide a 67% hedge against the interest rate risk in your liability. Now, suppose rates drop 1%. Your bonds and swap go up $80 million while your liability increases $120 million, so your hedge protects you pretty well—your funding ratio only drops to 96%.” However, he asks, what do you do now? “Your 60% equity weight has fallen to below 56%, which argues for selling bonds, but your hedge has dropped from 67% to 63% of your liability, which argues for buying bonds. Or maybe you ought to cut back your hedge since it's now less likely that rates will go down further, which again argues for selling bonds. Or maybe the fact that your liability is now bigger, and another 1% decline in rates would affect you even more than the first time, means you need more hedge, which again argues for buying bonds. Which is it? Or do you somehow rebalance using your swap? Are you more concerned about your equity weight and swap proceeds (impact on long-term returns), or your hedge in dollar duration terms, or your hedge as a percent of liability, or some metric like ‘1 in 20 worst case dollar impact on plan sponsor', or what?” While Vivian freely admits that there is no obvious right answer, he asserts, “You need to have thought out what you would do in this situation, what your consultants would have you do, and what your Board would have you do, and discuss, resolve, and document it all, well in advance.”
If Vivian is to be believed—and with his pedigree as a leader in this space, there is no reason he shouldn't be—then there is a gaping hole in LDI implementation. Pension plans would be well advised to fill it in before the next crisis hits. -Kip McDaniel