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Liability-driven investing (LDI) doesn’t have a George Washington or Thomas Jefferson. It does have a Constitution.
The history of a formal LDI theory is littered, it seems, with false starts. Academically, corporate pension plans were commented upon as far back as 1934, when Benjamin Graham and David Dodd of securities-analysis fame advised market participants to view these promises as an investment at market value less a debt on the firm—the liabilities implied by the pension promise. Forty years later, the giants of 1970s financial economics—Fischer Black, Bill Sharpe, and Jack Treynor—all commented on pension obligations relative to company value. Applying this theory, Martin Leibowitz did significant work with asset-liability management, and is perhaps the most important of these men—possibly alongside Jess Yawitz and Bill Marshall at NISA Investment Advisors—regarding the ultimate emergence of modern-day LDI. None, however, can claim to be a singular dominant figure behind the secular trend towards duration-matching and interest rate hedging in corporate pension portfolios.
Yet, an argument can be made that despite this dearth of Washingtonian figures, LDI does have its Constitutional equivalent: a little-known 1997 paper on pension obligations and mark-to-market accounting that arguably comes the closest to modern LDI’s founding document, written by C.J. Exley, S.J.B. Mehta, and A.D. Smith and titled “The Financial Theory of Defined Benefit Pension Schemes.”
“There was a long period where the mainstream view was that these pension obligations were all very long term, that short-term volatility didn’t matter and that, as a result, they shouldn’t have to suffer mark-to-market,” says Mick Moloney, Mercer Investment Consulting’s long-standing resident Guru of LDI and one of the few individuals in the pension business with a horizon-view of this investment strategy’s history. “They all said ‘Let’s not talk of short-term discount rates, let’s have a fixed rate and think as long-term investors.’ I think that whole thing began to change in the mid-1990s, and, specifically, with that paper.”
The paper (a rather dry piece of literature, even by academic standards) was focused on the United Kingdom’s (UK) market—note the usage of “Schemes” instead of “plans”—but its basic tenets applied universally. “We have… set out a blueprint for a market-based approach to valuation using the conventions adopted successfully by banks,” the authors stated. “Our conclusion is that, although historically a distinction has been drawn between asset and liability management by banks and pension funds, financial theory offers no good reason for this distinction.” Time to stop treating pensions as anything special, the authors were saying. They’re the same as any other liability—and time to show that on the balance sheet.
This 100-odd page tome, left alone, would have been one of hundreds that year touching on corporate balance sheets. However, the influence this paper had—directly or indirectly—would affect pension plans worldwide. “They were talking about stuff from the 1950s, but they dragged it back into the mainstream,” Moloney says. “You subsequently had regulatory and accounting changes which could have almost been written by the authors.”
If “The Financial Theory of Defined Benefit Pension Schemes” is LDI’s Constitution, the subsequent governmental and accounting regulations are its Bill of Rights. It’s easiest to think of these reforms in two parts: accounting reforms that forced corporations to be more transparent regarding their pension funding levels and benefit obligations, and solvency regulations imposed by governments on these pension plans. These reforms—sometimes paired, sometimes separated—took hold at various speeds across the obvious markets—the UK, America, and the Netherlands—containing large defined benefit pension plans. “The way I think about it is that it started in the UK, then the Dutch leapfrogged the UK while the US’ evolution was slower,” says Moloney.
The UK moved first, imposing FRS 17–the accounting standard, effective in 2005, which forced balance-sheet transparency of funding status, plus valued assets at market value, according to Moloney. (UK solvency standards are “principles-based rather than prescriptive” and are strictly regulated, although no specific funding ratio is demanded, says Moloney.) The Dutch government then imposed its even-stricter FTK reforms in 2007, which forced a stringent mark-to-market accounting and solvency standards that gave its large pension plans a limited timeframe to fund their plans to 105% levels. The US moved more gradually, implementing accounting rule FAS 158 in 2006, which forced pension over/under funding to be reported as an asset/liability in company financial statements. On the solvency side, it also enacted the Pension Protection Act of 2006, which standardized the timeframe over which a pension had to be fully funded, and limited smoothing of assets and liabilities on the balance sheet, effectively bringing pension volatility to the fore. At the same time, you had analysts beginning to publish smarter views on how pensions should be thought of in a holistic corporate sense, Moloney says—a regulatory, accounting, and awareness onslaught that pushed corporate pensions worldwide towards transparency, solvency, and a greater awareness of pension plan volatility’s affect on the corporate bottom line.
The outcome of the academic paper and government and accounting action varied by country, but the secular trend, in hindsight, is clear: a shift towards asset-liability matching, intended to reduce pension volatility and its subsequent effect on corporate profits. It didn’t happen overnight, of course. “One of the ’97 paper authors was a Mercer guy—so we had a strong voice in-house through the ‘90s,” Moloney says. “To some extent, though, you can push the envelope a little bit, but you can’t go faster than your clients. Accounting standard changes in particular were instrumental in influencing CFO and Treasurer behaviors. In the late 1990s and early 2000s we saw early signs of this, but from 2005 onwards we saw people in earnest really say they need to extend duration and think about a sensible, economic, mark-to-market measure of liabilities.” Markets intervened, however, and complete immunization remains a distant goal for most plans worldwide. “Very few plans have done the Full Monty of 100% hedging,” Moloney says, adding that the current state of LDI thinking can be characterized in one of three boxes, “not necessarily distinct. Box one companies often have open plans, still believe that investment risk-taking defeases cost of delivery of pension benefits for shareholders, and are willing to accept material levels of funding volatility. Box two consists of companies who want to get out of the pension-risk business but are still happy to retain assets and liabilities on the balance sheet in a low-risk mode. Box three, still small but growing strongly, consists of those who want to shrink their exposures through some combination of lump sums and insurance company annuitization.” For boxes two and three, Moloney concludes, “They’re thinking they want 110% funding before de-risking, but they’re at 70% now.”
That problem is where the LDI market stands today. Whether the myriad regulation and accounting standards—the real-world output of LDI’s founding document—have increased the stability of the defined-benefit pension system at the expense of corporate robustness is debatable. That they have changed the face—and portfolio construction—of corporate pension plans worldwide is not debatable at all.
-Kip McDaniel