Increasing Complexity

From aiCIO Magazine's 2011 Liability-Driven Investing Issue: If the world ran out of long bonds, what would plan sponsors do?

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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?

Askany 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.

It’s hard to draw easy takeaways from something as large and complex as the financial crisis, but these three might be a good start: 1) beware complexity, 2) counter-party risk is all too real, and 3) treat derivatives like the “financial weapons of mass destruction” that Warren Buffett once called them. However, if you’re looking to hedge interest-rate risk in an LDI portfolio, you might actually need to embrace derivatives—and the counter-party risk and unintended consequences that come with them. “There’s only so much of your liability that you can hedge with physical assets,” says IBM pension fund manager Ray Kanner (IBM being one of the well-known front-runners with LDI implementation). “If your hedge ratio is going to be more than your physical allocation to fixed income assets, then you pretty much will need to use derivatives of some kind at some point.” 

The primary derivatives used for LDI hedging are, of course, interest rate swaps. If interest rates go down, the portfolio takes a hit, but the funds get paid from the swap. If rates go up, they have to pay off on the swap, but the portfolio and liabilities should be doing well enough to cover the cost of being out of the money on the swap. A more recent development is what’s known as a swaption, which is an option on an interest rate swap. Interest rate swaps are amongst the oldest, simplest, and most well-understood derivatives, but they create a raft of questions and uncertainty for asset owners—to say nothing of lesser-known swaptions and other exotic instruments. Do we really understand how all these derivatives work? Who are we doing these deals with, and can we trust them?

“It’s an issue that has had to be addressed at the investment committee level,” says Martin Jaugietis, director and head of LDI solutions for Russell. “They hear the word swaption and they immediately think they are being sold some sort of magic potion. So the plan sponsor needs to understand how the swaption exposure fits within its overall LDI hedging program, how effective exposures are being monitored, and who its counterparties are.” 

One of the biggest concerns for any derivatives trade is counter-party risk. In essence, hedging through derivatives is like buying insurance—but, as the American public found out thanks to the likes of AIG, there are no guarantee in the de facto insurance of derivatives, and lobbyists worked very hard to maintain that state of affairs even through the Dodd-Frank reforms. The same went for proposals to put derivatives onto open exchanges where there would be transparency and greater competition—with the regulations either killed or significantly weakened. Derivatives are still traded in secret, with large fees for the investment bank middlemen and little built-in protection for newcomers to the game looking to hedge a portfolio. Big institutional investors have been burned before by all manner of derivatives and sophisticated financial instruments. They are right to be wary about them now. 

“A lot of people have tried to sell us on a number of LDI ideas. Total return swaps, longevity swaps, specific derivatives for our unique liability profile,” says Mark Gibbens, Alcatel-Lucent’s Head of Corporate Finance and Chief Investment Officer. “But we didn’t use sophisticated derivatives, which I’m very wary of… We didn’t do any overlays, and were very cautious about complex derivatives. In my earlier days in treasury I had to unwind a complex portfolio of derivatives. You couldn’t get a good sense of the market for them, couldn’t price them well. You could mark-to-market on simple derivatives but not complex ones.”  

Instead, Gibbens and Alcatel-Lucent—which has nearly $40 billion in pension capital—chose fixed-income benchmarks with credit and durations that matched their needs, without getting very deep into the derivatives market. Because of time limits on the duration of cash instruments, it can be difficult to match liabilities beyond 30 years. Gibbens says this might be something they need to use derivatives for in the future, but for now the trade-off is worth it.  

Avoiding derivatives may also be a function of the kind of skills and expertise that, frankly, plan sponsors are able to afford. Derivatives trading can be one of the most complicated, and potentially lucrative, paths on Wall Street. While corporate pension plans are able to pay more than their public-sector counterparts for top-quality talent throughout treasury and benefit departments, it is difficult to compete with Wall Street. Additionally, derivatives will be only one small part of a CFO’s/CIO’s daily mandate—which compares unfavorably to a derivatives traders at a big bank and hedge fund. In the zero-sum world of swaps and options, that means being on the other side of the trade from most asset owners. 

That’s not to say Alcatel-Lucent doesn’t ever use derivatives, Gibbens insists, but only individual managers with expertise and solid operations are allowed to trade them. That’s an approach that Kanner of IBM, who is more open to derivative usage than Gibbens, also advocates. “Six years ago we started a pilot, with just a little exposure to interest rate swaps, to understand the mechanics of how it worked, what type and credit quality of collateral we wanted to post and accept, how often it would be posted, how the mechanics of posting the collateral operated, and so on. We started with the pilot until we were comfortable that there were no wrinkles. And only when the pilot operated for some time without issues did we feel confident in expanding the program.”

For funds looking to hedge some of their interest rate risk, even consultants and banks—who have a distinct financial advantage selling derivatives and other complicated financial instruments—recommend that same kind of caution.  “It’s a long process,” Cutwater’s Lisella says of converting to LDI and hedging interest rate risk. “Often, a client’s first step is to transition the portfolio from an intermediate duration strategy to a long-duration strategy. The next progression is to begin implementing a fully customized, actively managed fixed-income portfolio tailored to the client’s actual liabilities.  Generally, cash instruments only go out to 30 years, and for plans seeking the most precise duration match, that’s where derivatives come in.” Multiple vendors interviewed for this article claimed that many clients are skeptical of using derivatives, especially mid-sized plans. “[But the] conversations about using derivatives as a risk management tool are becoming more common,” according to Lisella. “About a year ago, it was about educating clients about why LDI and interest rate hedging make sense. Due to low funded status and the interest rate environment, now many more plans are saying, ‘Even if we’re not ready to implement LDI today, we want to set a plan for de-risking once funded status improves or interest rates increase.’”

For all the concerns about derivatives and complicated instruments raised by the recent financial crisis, there is an irony: Funds that did more complicated hedging came out of the debacle stronger than those that didn’t. “The function of how well your plan did during the crisis was pretty much driven by how much interest rate risk you had hedged,” says IBM’s Kanner. “The higher your hedge ratio, the better you ended up doing. As interest rates fell, your physical fixed-income assets, as well as your derivatives, increased in value and helped mitigate the damage from the decline in equities, both in absolute and surplus space.” It may be complex—but it was worth it.  

-Joe Flood