Assessing Pension Schemes’ Balance of LDI Strategies

Russell Investments found six reasons why fiduciary managers must incorporate approaches beyond the oversimplified LDI strategies.

(December 16, 2013) — Fiduciary management investment strategies for pension funds should be more nuanced than “LDI+DGF”—liability-driven investing (LDI) and a diversified growth fund (DGF), according to Russell Investments. 

A mere combination of these two strategies may result in “sub-optimal portfolio construction,” found Gwion Moore, director of EMEA clients strategy and research at Russell. Investors, instead, should extend their responsibilities to properly control their risk exposures and make appropriate investment decisions.

Moore outlined six reasons why and how investors could offer beyond a simplified integration of LDI and DGF strategies.

1. Investment objective and investment horizon

According to Moore, the investment goals of LDI and DGF investors differ: LDI or pension scheme investors think long-term while DGF investors rely on total returns over a short-to-medium term horizon. These differences could impact “interactions between the growth and matching portfolio,” and investors must aim to target a suitable middle ground.

2. Stability of beta exposures and the concentration of risk positions

“Pension schemes are too important to fail,” Moore said. A less approach “is less appropriate for the semi-public institutions that are defined benefit pension schemes.”

The “racier” strategy of DGF involves risk exposures that pensions may not be able to stomach. Moore suggested that such opportunities could upset the “balance of risk premia and market beta exposures,” making funds vulnerable to the wrong kinds of risk.

3. Integrated risk taking and solvency management

Moore found pension investors must step into the role of a “solvency manager”—determining the proper risk in finding the optimal balance of the growth and matching portfolio strategies.

He continued to say that perfectly hedging liabilities might not be most constructive to certain pension funds—and the same applies to an optimal growth strategy. Establishing whether to overweight or underweight a certain asset class and risk is one of the most significant jobs of fiduciary managers.

4. Role of interest rate risk in the growth portfolio

While most investors attempt at completely severing the growth and matching portfolio, Moore found many are unsuccessful. In such cases, DGF strategies of introducing interest rate duration—through allocations or derivatives exposures—such as risk parity could be “poor portfolio construction.

“The most efficient way to introduce interest rate and inflation risk into a pension portfolio is through levered exposure in the matching portfolio,” Moore said. “Introducing fixed exposures to interest rates into the growth portfolio is often just a case of wasting capital that could be better spent.”

5. FX risk as the point of intersection between growth and matching

Looking specifically at FX/liability hedging policy, investors should observe the correlation between FX rates and real interest rates, according to Moore: “Pension schemes which set their FX hedging policy based only on a single asset class or on the growth portfolio alone will have had too much hedging of FX risk.”

For certain pension plans, FX risks could drive movements in interest rates and inflation that could inevitably impact liabilities.

6. Impact of interest rates versus equity correlation

According to Moore, the correlation between interest rates and equities could impact both DGF and LDI investors’ goals—even pushing the two to opposite sides.

With a positive correlation, DGF investors enjoy an “off-set” of equity and interest rate risks. When negative, the volatility of the funding ratio for LDI strategies decreases.

“This means that in order to maintain a volatility target, the DGF investors moves to a more conservative strategy (decreasing equity exposure), while the pension scheme investor is able to move to a more aggressive strategy (increasing equity exposure),” Moore said. 

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