Is LDI Dead?

From aiCIO's November Issue: Delving into a question that tantalizes both supporters and opponents of liability-driven investing (LDI). 

To see this article in digital magazine format, click here.

Is liability-driven investing dead? It is a question that tantalizes both supporters, who perhaps secretly fear that it is, and opponents, who possibly suspect that the answer is no.

The above paragraph, by almost any measure, is plagiarism. In 1966, Time magazine asked “Is God Dead? It is a question that tantalizes both believers, who perhaps secretly fear that he is, and atheists, who possible suspect that the answer is no.” While the iconic cover of that Easter-week magazine was remembered long after the article it represented was forgotten, its thesis was this: While 97% of Americans believed in a God, their relationship with Him (or Her) was changing. It wasn’t so much that God was dead, but that older ways of relating to Him were. It spoke to a post-war moral crisis, the discombobulating chaos of the 1960s, and perhaps some overly serious inquiry about that which is inherently uncertain.

Just as 97% of Americans claimed belief in God when Time asked that question, an overwhelming percentage of pension funds and the people who service them currently believe in the holiness of liability-driven investing—LDI, in industry parlance. Yet like God, those who tout LDI perhaps secretly doubt its veracity, and those who reject it possibly doubt its fallibility.

So now is the right time to ask a similar question. Is LDI dead?

To answer the question of death, the issue of birth must be addressed. While Martin Leibowitz—he of immunization fame—is rightly credited with bringing LDI into the post-Employee Retirement Income Security Act (ERISA) pension era, the foundation of his work on “cash matching” portfolios lay before, during, and just after the Second World War.

The War era, it seems, sparked a small revolution in fixed-income investing theory. The idea of duration for fixed-income securities was first espoused in a 1938 study; a 1942 paper pointed out that by matching the duration of assets and liabilities, interest rates would have a somewhat or entirely neutral effect on portfolios; independent academics quickly came up with similar theories, suggesting a fragmented group of men (and yes, all men at that point) working on the idiosyncratic problems of portfolio matching.

This fragmentation ended with Frank Redington. Unlike the other authors of fixed-income duration work at the time, Redington was not an academic. Instead, he was an in-house actuary for the United Kingdom insurance company Prudential. In 1952, he penned “Review of the Principles of Life-Office Valuations,” a strikingly boring title for what would turn out to be a seminal document in immunization theory.

Redington’s prose (unlike his titling ability) is vibrant in a way that only a non-academic could achieve. “The original purpose of this paper— undertaken at request but not unwillingly— was to review the principles and practice of life-office valuations in the light of modern conditions,” he wrote. “It was difficult, however, to deal satisfactorily with the principles of valuation in vacuo without reference to more fundamental principles. As a consequence the paper has become more ambitious in its scope than originally intended— and has threatened to run away with itself. The reader will perhaps be less disappointed if he is warned in advance that he is to be taken on a ramble through the actuarial countryside and that any interest lies in the journey rather than the destination.”

This ramble, it became clear, was more a dive into an entirely new way of thinking about bond portfolios. The crux of it was this: “The word ‘matching’ implies the distribution of assets to make them as far as possible equally as vulnerable as the liabilities to those influences which affect both. This implies the distribution of the term of the assets, in relation to the term of the liabilities, in such a way as to reduce the possibility of loss arising from a change in interest rates.” Put in context, this was the first direct discussion of how institutional portfolios could protect themselves against interest-rate risk.

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Then, for a quarter century, Redington and his work were largely forgotten. Only in the early 1970s did immunization theory re-emerge. Perhaps a result of rising interest rates, this refocus culminated in the late 1980s work of Salomon Brothers’ Leibowitz and a few others (including Jess Yawitz, now of St. Louis-based NISA Investment Advisors) who married the theory of immunization and its practice in ways unseen until then. Redington’s theories had been vindicated and sometimes implemented (and led to him being named the “Greatest British Actuary Ever” by trade publication The Actuary), a new set of immunization stars had emerged, and uncertainties within bond-based portfolios, it seemed, were going the way of the dinosaur.

But despite the seemingly sound logic of LDI, only a rarefied few had refocused their pension management toward duration matching and immunization by the turn of the millennium. Rising stock markets following the dot-com crash did little to change this stasis. However, a swath of government regulation—America’s Pension Protection Act (PPA, 2006) and the Netherlands’ FTK regulation being the prime examples—along with various accounting reforms gave theory a kick in the pants. No longer was immunization an ideal. It was now practically a requirement. Many plans, if they hadn’t already, began to explore LDI implementation, even as equities hit all-time highs in the fall of 2007 and global markets seemed to forever and steadily grow. Which brings us to the halcyon days before the world economy hit a brick wall.

“We’d love to say we’re geniuses, but we’re not,” Kathy Lutito said as she sat in a windowless conference room on the 38th floor of a non-descript office building in downtown Denver. Lutito is the chief investment officer for the CenturyLink Investment Management Company, a separate subsidiary of communications firm CenturyLink. Beside her at the conference table were her lieutenants: Paul Strong (VP of public markets), Shane Matson (also VP public markets), John Litchfield (VP of private markets), and Mary Beth Gorrell (VP of strategy and asset allocation). “We were lucky. Plain old lucky.”

“I mean, people can ask the right and wrong questions,” Strong—a jovial Nebraska-native—interjected. “We were, I think, asking the right questions—but to say that we had any great foresight into the coming financial crisis, that would be wrong.” A chorus of agreement and head nods greeted Strong’s comment, with murmurs of the PPA and accounting rules scattered about the room. “Prior to the PPA and accounting changes, pensions were footnotes,” he continued. “Afterwards, the difference between assets and liabilities had to be on the balance sheet. That focused a few minds, to say the least.”

The CenturyLink pension brain trust was in this room to discuss one thing: How the fund survived the perfect storm of falling interest rates and equity markets in 2008 and beyond. The $12 billion pension—or, more accurately, the Qwest pension that was acquired by CenturyLink in 2011 and whose legacy benefits still comprise a bulk of the CenturyLink pension system—is one of those smart and lucky funds that moved quickly into LDI once the PPA was implemented.  “In 2007, our funded ratio was about 120%,” Lutito said. “We looked at the funded status, how large the pension liability was compared to the market capitalization of the company, the impact of the new funding and accounting rules, and then looked at many ways to reduce risk. We decided on LDI—reducing risk in the asset portfolio.”

“First we had to go to the Board, of course,” Lutito added, with agreement from all sides. “They asked, like almost anyone else would, who else was doing this. We mentioned a few names of other funds that were moving in the LDI direction, but there weren’t a whole lot. But the board was convinced and we started to move.”

The fund took three distinct steps as the wave of world markets crested in the autumn of 2007: they reduced equity exposure, they raised their fixed-income allocation and extended its duration, and they instituted synthetics and derivative programs. By mid 2008—before the fall of Lehman Brothers—they had completed what Lutito called their “hedging period” and had attained their hedge goal of 60% through physical assets and overlays. A lot was accomplished in a small span of time, Strong noted, which brought its own challenges. “There are certainly challenges with taking big moves like this—but we took a measured pace, we think,” Strong added. “There are practical things to be done—finding managers, getting all your documents in order, as well as telling some equity managers about your plans.” 

And then the financial storm hit. “Our biggest regret then?” Lutito mused. “We didn’t go to 100% hedged in 2007. That’s the biggest one.” 

The conversation then shifted to what the CenturyLink team had learned since the crisis—and how their collective vision of LDI had changed. Words like “process,” “education,” and “evaluation” were batted around frequently, as was a more unexpected one: “belief.”“The single most important thing for us after the markets crashed was a belief in what we were doing,” Strong said with a surprising amount of force. “You need to believe that you’re on the right path, regardless of what markets are doing at that very moment.” 

“There was certainly skepticism,” Lutito added. “But then there was continued education and the process of building an understanding of the importance of reducing risk that allowed people to be supportive. ‘Persistence’ is the word that springs to mind.” 

Gorrell agreed. “The key is making sure that all the parties involved realize that this is a long-term strategy, not a market timing call,” she said.

“And you need to be flexible,” Litchfield added. “Tacking onto what Paul [Strong] said, having a firm set of beliefs, and being flexible in implementing those beliefs, is important.  Try one thing, and if it doesn’t work, recast in a different direction.” Among other things, this reflects the fund’s willingness to be active with their hedge: in 2009, they reduced it from 60% to 30%, a result of a changing view on interest rate levels.

“Which, with perfect hindsight, our funded status would be higher today if we maintained our hedge,” Lutito added. “This was an important lesson that helped guide us toward implementing a more disciplined, but yet flexible, de-risking glide path framework based on funded status.”

None of this could be possible, of course, in a fund that moved as lethargically as critics often accuse pensions of being. CenturyLink Investment Management is run as a separate subsidiary of the parent company. It has its own board—comprised of the CFO, Treasurer, SVP of Human Resources, an external advisor, and Lutito—that gives the asset management team a great amount of freedom. “It’s what some people call ‘empowering the CIO and her team,’” Lutito noted. “We have control over asset allocation, manager selection, risk management, and other strategic decisions.” This “strong delegation” allows the fund to be more nimble than it otherwise would have been—seen most importantly in the speed with which it transitioned billions of dollars of its portfolio as the crisis was cascading. 

“There is definitely not a ‘well worn path’ on how to implement such a strategy,” Matson added.  “Every plan has unique characteristics that must be considered. Finding the best route to reach our plan’s objectives is the key, even though it’s likely no one else has gone that way. Although it often feels like we are out on the frontier”—and he wasn’t referring to Denver here—“I wouldn’t want it another way.”

“This structure, and the experience of the last five years, allowed us to be more intuitive regarding how we manage the assets,” Gorrell added.

“I think we’ve learned to look at the bigger picture,” Lutito concludes. “We’ve learned to really consider enterprise risk. What if another 2008 happens? Can you survive? When I hear that other funds want to do LDI, but can’t do it right now—I question whether they are looking at the risk to their company, or the current interest rate environment. If rates decline further, the alternative (not hedging some portion of the liability) may be worse.”

In late October, Lutito got on the phone with me from a Committee on the Investment of Employee Benefit Assets (CIEBA) meeting—the organizing entity and lobbying body for the largest corporate pensions America-wide. 

“LDI requires a lot more creativity now than even five years ago,” she said from Washington, DC, when asked about LDI’s survival after the crisis. “The easy path has passed. It’s just a different time now. At the time [before the crisis], we thought rates were low—but obviously they are much lower now.” These “incredibly low rates due to the Federal Reserve’s massive intervention in response to the global financial crisis” are the biggest struggle for LDI now, she said. “Rates on the 10-year Treasury were at 4.5% when we first started LDI and we never imagined they would be where they are now. We’re at about 1.8% now on the 10-year, but we have learned rates can always go lower.” 

Because of this government intervention, she noted, and “because of the European situation and volatility,” people aren’t moving—or at least aren’t moving quickly. “Why would you want to buy Treasuries right now? From an investment perspective it doesn’t look like a great opportunity, but from a hedging and risk perspective it may be appropriate.” LDI is by no means dead, she believes, but “if you are structuring an LDI portfolio today, as opposed to when we did [in 2007 and 2008], you would do it differently. Previously, we sold equities and bought long duration corporate bonds and Treasuries. In today’s environment of low Treasury yields and tight investment grade credit spreads, you need to be creative in finding investments that are correlated to the liability, but have better return potential than long duration investment grade bonds.” Some examples would include emerging market debt or even private structures, she noted. “Reducing the risk profile of your equity assets can also be an attractive alternative. However, you still need to manage overall duration risk compared to the liability, which may need to include derivative exposure. Our portfolio looks very different today, as a result of the current market environment, than it did when we first implemented LDI.”

Perhaps what’s more important, Lutito noted, is the increasingly accepted idea that LDI is “really unique for each company. It’s almost, by definition, a customized approach for each company.” And this extends further than LDI, she said, for the end game is also unique to each sponsor. “What we’re seeing now, with the pension risk transfer announcements, is companies saying that the pension obligations are a problem and a distraction from running their main business. They just want to make it go away. In the current environment, it seems that some companies are willing to pay a premium.”

Perhaps, then, a more radical thought isn’t that LDI might be dead. Instead, do the GM and Verizon pension risk transfer mega-deals signal that final arrival of the long-predicted death of another pension stalwart—the defined benefit plan itself?

“Less radical Christian thinkers hold that at the very least God in the image of man, God sitting in heaven, is dead,” wrote John Elson in the Time cover story. “[T]he central task of religion today… [Is to] seek to imagine and define a God who can touch men’s emotions and engage men’s minds.”

This evolution of religious thought can be measured in centuries—for what is the Time cover story but a modern version of the Protestant Reformation? Not so with the evolution of LDI. Like God, the contemporary idea of matching pension assets with liabilities isn’t dead, but it’s also not the same asset matching that Lutito and her team discussed in 2007. It’s not even the same LDI that they discussed in 2009, when they decided to slightly re-risk. As Lutito herself said, it’s a different time now.

It will be ever thus. From the theory of Redington to the implementation of Leibowitz to the successful pre-crisis days for a minority of funds, LDI has always been changing—and will continue long after this article, like the original Time feature, is forgotten. 

—Kip McDaniel

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