A Liability Paradigm Shift | Chief Investment Officer

Legal & General Investment Management America (LGIMA) sees a wave of change in LDI toward liability-based benchmarks. Jodan Ledford, Head of US Solutions, and Don Andrews, Head of Solutions Strategy, sat down with CIO to discuss the paradigm shift and innovations in LDI for small and even defined contribution plans. Q: When CIO met with LGIMA last year, we talked about the spectrum of de-risking and how there is a lot of tracking error between market-based benchmarks and corporate defined benefit pension liabilities. Does this still stand true? Jodan Ledford: Absolutely. Liabilities are discounted using high-quality corporate bonds, mainly AA or higher—a universe that is actually very small and concentrated. There is a much wider array of bonds in market-based benchmarks, and therefore, they fluctuate a lot differently than liabilities. From that perspective, in periods of high-stress in the markets, like first quarter this year, you saw a lot more volatility from the full investment grade universe of bonds than you did from the liabilities that are discounted using higher quality corporate bonds. But because the higher quality spectrum is so concentrated, an investor would generally avoid owning a portfolio of bonds focused solely on that quality spectrum because they would end up with the top five names in their portfolio making up 40% to 50% of their overall holdings. This concentration amplifies the risk if there’s a shock to the market and some of those bonds get downgraded, as the investor would be holding a lot of assets that are worth much less than the liabilities. This is important because you want to effectively look at the quality of your liability basis when structuring a risk management solution. How do you utilize the full market from a prudence perspective as an investor to manage against liabilities? For example, an investor may not want to own a dollar of corporate bonds in the full investment grade market spectrum against a dollar of liabilities, because it could result in an LDI program that is fairly volatile with respect to the liabilities. This is not meant to detract from the value and importance that investment grade corporate bonds or credit plays within an LDI framework—actively managed credit is crucial to a successful outcome. However, we would recommend the investor beta-scale the allocation to full investment grade credit versus the liability basis, and invest the remaining balance in Treasuries. This allows them to not only balance out the quality spectrum of their assets versus their liabilities, but also manage against the risk of the liabilities themselves, which have a much different cash flow profile than that of the investment grade credit universe. What we have seen this year is a tale of two quarters. The beginning of Q1 was much like Q4 of last year—BBB corporate bond spreads widened at a much faster pace than the higher quality liabilities. Which meant if you were holding a dollar of long credit assets versus liabilities, you would have lost more on your assets than your liabilities, which would have resulted in a decrease in funding ratio. Q2 was a bit more risk-on—equities did well and credit spreads tightened. So from that perspective, the tracking error was equally as large between Q1 and Q2, only the latter was positive while the former was negative. We have seen many clients start to recognize this as they began to invest more and more assets into fixed income. They were always told that their corporate bond allocation is their secret weapon against liabilities. But actually managing against liabilities is much more intensive, forcing you to think about investment strategies other than just fixed income allocations. If you want to improve asset-tracking versus liabilities, then moving to a long corporate bond mandate will help lower volatility overall from your assets versus liabilities. But when you focus on how that component is doing against liabilities, you’ll see a lot of tracking error. Q: Why aren’t CIOs immediately jumping to liability benchmarking and moving away from market-based ones? Ledford: It’s a progression for committees. It’s easy to go in and see how a corporate bond manager is doing against a market-based benchmark. It’s the market. They’re measured against how they perform against it. And, as mentioned, market-based actively managed fixed income mandates are vital to the success of an LDI solution, so there is an important role played by those mandates. It is the process of translating the movement of those assets to the movement of plan liabilities that can be challenging. Liabilities, unlike assets, include uninvestable components that need to be attributed when explaining why the change over a period was from x to y. Generally, at least within the fixed income world, there are few investable assets that provide cash flows beyond 30 years, whereas liability profiles extend anywhere from 80 to 100 years. Thus, changes in long-end yields will impact the assets and liabilities differently. It is important to not only identify why the liabilities changed over a period, but also translate that in to what success looks like for an LDI program. At the end of the day, it is making your liability-hedging assets operate as efficiently as possible against your liability returns. Liability benchmarking is a different way of thinking about pension plan investment strategy—a paradigm shift that focuses on managing your assets in line with your liabilities. Committees are comfortable doing what they’ve been doing, and it’s difficult to switch that lens. But I do think that shift is coming, as we’re seeing more and more clients switch to this more customized benchmark. Ultimately, the objective should be managing toward the liabilities by utilizing the most effective instruments available to investors, which generally includes a mix of active credit with custom Treasuries. Q: If an average corporate plan wanted to shift the paradigm toward liabilities, what steps do they need to take? Ledford: The first step would be to conduct an asset-liability study with plan consultants. This would enable them to develop a strategic glidepath, which will help determine how much they should allocate to liability-hedging assets versus return-seeking assets. The lower funded they are, the more equity-like assets they’re going to have. As they get better funded, you start allocating more and more to fixed income. Along this glidepath, you can develop a plan with a liability-returns perspective. Next, the plan needs to generate a platform that tracks liability change on a monthly or quarterly basis. They must be able to attribute changes to interest rates, credit spreads and/or benefit payments. Once attribution is determined, plans can then think about which instruments they will use to offset these changes. Lastly, they can start synthesizing liability returns into investment returns, providing a framework for measuring success—whether it is with one manager or multiple. Q: In situations that require multiple LDI managers, what can a completion manager bring to the table? Ledford: When it comes to changing plan governance and moving away from a market-based benchmark, there are not many managers with the capability to translate liability returns into a performance target. Completion management allows you to adopt a liability-return framework while maintaining diversification in manager line-up. A completion manager can look at what these managers are invested in—not necessarily their specific physical holdings, but rather the dollars allocated against individual benchmark strategies. With this in hand, the completion manager can fill in the gaps to deliver the hedge targets, enabling the overall plan to still be measured against the liability returns. Don Andrews: Completion management primarily focuses on interest-rate and credit-spread hedging. A completion manager deconstructs the liabilities into key-rate duration exposures and translates those market-based benchmark manager allocations into something that looks more like the liabilities to achieve the target hedge objectives. As a completion manager, LGIMA often manages large Treasury portfolios structured to provide customized interest rate exposure. We often are able to dual purpose these Treasury pools as collateral for other exposures as well. Equities are a popular exposure to replicate synthetically in the derivative markets. This can be done in a variety of ways, from implementing very basic strategies through futures and total return swaps to more complex option-based strategies. One strategy that has gained a significant amount of interest is put-writing, which takes advantage of the shortage of natural put sellers, particularly given recent regulatory changes. Using Treasury portfolios to deliver interest-rate hedge and support equity exposure has gained a significant amount of interest over the past couple of years. As a result, we recently launched a Multi-Asset Portfolio Management team to focus on these types of cross-asset solutions. Ledford: Think of these strategies as liability hedging-plus. Andrews: Our Multi-Asset Portfolio Management team’s focus has been on developing cross-asset solutions, such as active equity replication, option-based strategies, defined contribution solutions and risk premia strategies. Because the Multi-Asset Portfolio Management team is housed within the Solutions group, and literally sits next to our LDI Portfolio Management team, both teams can operate very efficiently to target plan de-risking and exposure objectives–for example, dual-purposing of Treasuries for collateral management. Oftentimes, the Treasury collateral is supporting the interest rate hedging objectives of an LDI mandate and simultaneously supporting the collateral on equity exposures. Ledford: The team is looking at the same factors as smart beta—structural or behavioral factors in the market—to harvest some of those premia that fit in asset classes other than just long equities. We’re trying to skate to where the puck is going, not where the puck is now. We do not want to get comfortable with just putting on liability-hedging exposures to customize liabilities. We want to create more comprehensive solutions that optimize the portfolio, hedge liabilities and provide access to multiple other exposures. So, liability hedging-plus-plus. Q: What are the specific challenges that small plans face when they’re trying to de-risk? Ledford: Whether the plan is $5 billion or $50 million, a similar level of work and effort is required to analyze all the assets and manage a portfolio against the liabilities in conjunction with the assets. A larger plan has significant economies of scale. What it costs to manufacture a solution for a large plan is very reasonably priced, but it could get prohibitively expensive for small plans to implement a customized solution. To address this issue, we built a solution that offers a similar level of customization but in a pooled framework. This enables us to deliver customization to small plans at a much more affordable price. Which led to our development and launch of six different funds structured to work in conjunction with one another–three funds for each set of liabilities. One is focused on a retiree liability, so roughly a duration of eight to nine. The other is focused on a younger profile, so an active or a term-vested profile. These benchmarks are calculated externally by Bank of America Merrill Lynch. We’re managing toward the liabilities that are underlying the indices, not the individual plan liabilities. But because they’re focused on liability profiles, when you blend the funds you can closely match the majority of the liability profiles out there. It’s possible to use the different tools as levers to build a solution that tracks the liabilities closer than simply pairing a couple of different market-based strategies. These combinations allow many plans to employ customized investments for their liabilities. Andrews: We developed these six funds to target short and long duration liability profiles. There are three versions of each profile. The first is a corporate profile, which aims to hedge 100% of the interest rate and credit spread hedge risk of the liability. The second is an unlevered Treasury fund that hedges 100% of the interest rate exposure of the liabilities on a dollar-for-dollar basis. The third version also targets 100% interest rate exposure, but does so with substantially less capital by using Treasury futures. Other than Treasury futures, our pooled funds do not contain other derivatives. The pooled funds take on the challenge associated with the mismatch between market-based benchmarks and liabilities. We’re managing each of these six pooled funds as a standalone segregated liability benchmarking mandate against the six Bank of America Merrill Lynch benchmark indices, each and every day. Therefore, they receive the same level of attention and ongoing management from our LDI Portfolio Management team that any of our segregated mandates would receive. And on a quarterly basis, we’re able to rebalance those exposures to bring them back in line with the small plan’s actual liability. This level of customization maintains the necessary exposures relative to the plan liability, while offering daily risk management in a scalable process for smaller plans. Q: How do equity collective investment trusts (CIT) work with the pooled funds we talked about earlier? Ledford: You are effectively allocating money from one pool of exposure to another, so from that perspective, they are not necessarily attached to the liability pooled funds; they are separate and distinct. For example, we could implement a solution with an MSCI ACWI paired with a long corporate or a long credit. Here, we would be looking at the exposures and rebalancing back to target of the overall policy on a monthly or a quarterly basis. The equity CIT structure was launched for corporate defined benefit plans and defined contribution plans. In order to capitalize on the profitability of large-scale index funds, our Index team aims to use the pooled funds to deliver returns on primarily the S&P 500 (and subcomponents) and the MSCI ACWI Investable Market Index (in the subcomponents). With a lot of different pools of equity funds, the CIT structure enables us to deliver against those indices while having flexibility across the funds. From the multi-asset side—and from the DC solutions side—they are just tools in our toolkit enabling us to deliver outcome-oriented strategies for plan sponsors. So next year we’ll be talking about LDI in DC.