Increasing Complexity

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It’s a simple idea, but if you follow it out logically, it can get awfully complicated, awfully quickly. Liability-driven investing (LDI) operates off an undeniable logic: defined-benefit pension plans have to pay out, well, defined benefits, to their enrollees over long periods of time. After the financial crisis and the new Age of Volatility it seems to have ushered in, the stability and seeming predictability of a bond-based LDI portfolio has taken on a new appeal to many funds. But like almost anything in modern finance, the simplest of facades can mask the most complicated underpinnings, filled with multi-variable assumptions, foggy prognostications, and complex considerations.

The most important factor with pension fund liabilities is, of course, interest rates: Build an LDI portfolio with an overly bullish view of future interest rates, and lower rates will wipe out even the most carefully laid plans. Funds can immunize themselves against future rate changes through a variety of derivatives, but this raises a broader question. Aren’t these complicated financial products exactly what got the economy, and sometimes-naïve institutional investors, into so much trouble in recent years? Can pension funds acquire the necessary expertise to invest in these products without being the “dumb money” at the table the next time John Paulson and Goldman throw together a supposedly risk-free investment opportunity like the now-infamous ABACUS?

Ask any retirement planner or savvy 401(k) holder how they’re planning for their financial future and they’ll likely lay out a simple equation. First, you figure out how much money you’ll need to live on, and for how long. Then, how to save and invest to meet those needs. On a much larger scale, defined-benefit pension plans can be seen the same way—and what pension fund managers have going for them is the law of averages. Any given person has only a vague guess as to how long they’ll live. Pension plans, thanks to long-established actuarial tables and (generally) large numbers of retirees, have a fairly precise understanding of what they’ll owe out in future years. The idea that defined-benefit plans should take these future liabilities into consideration would seem to be common sense. After all, what’s a pension fund’s job, besides being able to make good on promises to retirees? In recent years, though, this core idea behind LDI was borderline outlandish. 

It’s not that the idea was so new and revolutionary. Everyone, from individuals planning their retirements to insurance companies trying to make sure they’ll have enough capital on hand to survive a major catastrophe, try to line up their assets with future obligations. Although they weren’t calling it LDI at the time, some asset managers were investing pension client capital in duration-matching portfolios more than 20 years ago. For most plans, however, the timing simply was not right. During the 1980s, many pension fund portfolios were performing so well that the last thing anyone wanted to think about was going to a conservative, fixed-income strategy that traded away big returns for stability. This only increased during the 1990s, when the booming stock market and accompanying New Economy boosterism had companies all but forgetting that pension funds were even a liability in the first place. Treasury departments and pension plans were making a killing on their investments. Microsoft, that most envied of 1990s corporations, grew its treasury from $5 billion to $80 billion in about five years. Any half-decent plan was making returns far in excess of what their increased benefit outlays looked like. For many companies, the pension fund was a way to dabble in the hot world of stock picking. 

“So much of the focus was just on maximizing returns,” says Bob Collie, chief institutional research strategist for Russell Investments in the Americas. “People were seeing pension plans as profit centers, not cost centers. So the idea that this was a liability and that that’s how you should invest was in the background.”

Then, the bubble burst. With a recession and the return of market volatility, executives returned pensions to their rightful space in the ‘cost center’ category. The idea of LDI began to make the rounds and gain theoretical acceptance—but then a resurgent early-2000s equity market left the idea of a portfolio driven by plain vanilla bonds too dull for many investors.

This changed though, with the Public Pension Act of 2006. Suddenly, private pension funds had to give the government, and enrollees, an accurate picture of funding levels, and fork over extra cash to the Pension Benefit Guaranty Company (PBGC) whenever those levels fell too low. That not only meant more transparency and a need for higher funding levels, it also made volatility a real enemy and LDI a more palatable option. Investment managers like Russell had been offering advice on strategies like LDI for years, but with the new regulatory changes and increased popularity, in 2007 they started offering a series of long-duration funds designed to match liabilities over long periods of time. And, although much of the financial crisis grew out of the bond markets, the hit equity markets took convinced even more funds that fixed income was the way to go. “In the last few years, our conversations have shifted from clients looking to understand LDI,” says Cutwater’s Kim Lisella, “to conversations about implementation and the path to de-risking. Clients are looking for ways to take risk and volatility off the table. We’ve had several instances of incredible equity volatility over the past 20 years, the kind that’s only supposed to happen once a century or so. The increased frequency and severity of equity volatility has caused plan sponsors to take the risk of equity volatility very seriously and begin developing a plan to de-risk the portfolio.”  

This sounds like the perfect environment for switching to a bond-based LDI, but one major obstacle stands in the way: interest rates. Treasuries are at historic lows. Corporates aren’t a whole lot better. The foreign debt market is a mess, thanks to the Sword of Damocles default risk hanging over the heads of Greece, Italy, Ireland, Portugal, and potentially even Spain and France. Rates will eventually rebound, of course, but prognosticators have been foreseeing that revival for years now without it coming to pass, and the US Federal Reserve has essentially guaranteed interest rates close to zero for the next year or two. Throw in the always-uncertain future of rates over the next 10, 20, even 30 years, and what seems like a simple, stable investing philosophy is suddenly looking a lot more up in the air. Wall Street has an answer to this uncertainty, of course, but it’s one that has plenty of investors wary.

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