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Many consulting firms help clients along the liability-driven investment path. Few, however, were founded explicitly to do so.
Meet Rocaton Investment Advisors, which has more than $300 billion in assets under advisement. In April 2002, the firm was founded by a group of industry veterans, all of whom emerged from fellow consulting firm Rogerscasey. The new creation remains employee-owned today as it approaches its 10-year anniversary. “You need minimum scale to have resources to advise on LDI, but rapid and significant growth of the firm will always be in the best interest of shareholders rather than clients,” says Robin Pellish, the firm’s CEO, from Rocaton’s Norwalk, CT office. “Being an employee-owned firm is really a valuable tool for aligning everyone’s interests and eliminating turf battles, getting people to focus on the target.”
In the past, corporate pension plan sponsors have been focused on the target of constructing a diversified asset portfolio that would achieve sufficient investment returns, working in combination with plan contributions to cover benefits promised to employees in retirement. That focus has now changed. Hit by the unanticipated volatility of plans’ funded status and a swath of regulatory and accounting rule changes, plan sponsors, investment managers, and consultants have been forced to adjust their approach, paying greater attention to plan assets in terms of liabilities.
Financial stress and uncertainty creates opportunities for innovation. The shift in focus has created the opportunity within the consulting world to provide advice to plan sponsors desperate for help with how to more clearly understand the sources of funded-status risk. Rocaton’s relatively recent inception—it was spawned during the funded-status roller coaster of the early 2000s—made a focus on liabilities naturally high up on its agenda. From 2000 to 2002, companies generally saw the funded status of their sponsored plans drop sharply. While they had been comfortably funded at 121% pre-crisis, they fell to around 77% at the end of the period, according to a research paper by UBS published in August.
Consultants and industry sources say that what makes someone good at thinking in an LDI point of view is someone who can think outside the box. “People who began to define LDI had a narrow definition of protecting interest-rate risk, but people who take a broader view—defining LDI as a way to protect corporate financials—have more success with the approach,” says David Service, a consultant for more than three decades at Towers Watson, another longtime proponent of LDI among corporate pensions. “I think the whole purpose of LDI is to try and lessen the concerns around what detriment the pension plan can do to the company. The more financially levered the pension plan is, the more important it is that the company manage that risk,” he says.
For LDI to succeed, Service and other consultants say, plan sponsors must clearly define the financial metrics which the plan must abide by. Better alignment is needed between the pension and the company, Service says, so that the pension doesn’t deliver bad news when the company is already experiencing financial issues. “The chief financial officer clearly understands the corporation’s business cycle, knowing when the firm will be scrambling for cash, understanding their operating profits,” he asserts, “so comparing that cycle to the cycle that drives pension plans becomes a critical factor.” Therefore, the CFO must understand the factors that cause pension contributions to increase. “If the pension plan is going to be delivering bad results during the time that the company is weak, the company needs to be more proactive about actively managing pension risk,” Service says. “The approach needs to make intuitive sense. I like to think in more of a CFO framework. Ultimately, as a consultant, you’re trying to make the CFO’s job easier. This also requires that you think of fiduciary duty in a broader context, as the duty to adequately fund the plan must be of primary importance.” The ultimate purpose of LDI, consultants say, is to try to ensure the plan remains viable and in effect for the long term, which benefits future and current generations of members. “The real goal of LDI is to mitigate damage,” Service concludes.
Rocaton represents nearly all those qualities. “LDI has gone well beyond a buzzword at this point, with more than half of Rocaton clients having implemented the strategy—and with corporate schemes planning to continue moving further down the path of reduced funded status volatility,” says Rocaton partner Joe Nankof. “Over the past five years, the strategy has gained particular momentum.” Nankof notes that LDI continues to be one of the highest priorities on corporate plan sponsors’ to-do lists.
The cohesiveness of Rocaton is evident in the manner in which Pellish and Nankof interact, sitting across each from each other at a conference table, not interrupting each other yet finishing each other’s sentences with details when needed. “Joe brings a host of technical expertise having been an actuary. He brings knowledge of the corporate pension fund universe—he knows what different funds are doing,” says Pellish. “Robin brings client-specific knowledge, and really understands the objectives of our clients,” says Nankof.
Due to Rocaton’s relatively small size, each consultant works with 10 or fewer relationships. “We’re all enmeshed in the details. If firms have 300 clients or more, you just can’t be as involved in both the big picture and details,” Pellish asserts.
The dialogue about the importance of LDI among corporate firms has gained prominence in recent years—a positive development for consultants ready to soak up the business. Describing Rocaton’s role in the grand scheme of LDI for their clients, Nankof says: “The analogy of how we implement LDI is like a game of golf. We’re the caddies to help the client navigate the course and hazards. Unlike a game of poker, clients can succeed without worrying and competing with other golfers.”
Rocaton’s basic approach to LDI is simple and straightforward: “This is not a buy-and-hold decision,” says Pellish, adding that the investment strategy is not the right answer for every client. “Often, we talk about a dynamic LDI program with clients. A certain LDI approach may be right for a particular client at a particular time, but as objectives, liabilities, and capital markets evolve, a different strategy may be appropriate. We discuss dynamic asset allocation and trigger points,” Pellish says, noting that the firm encourages its clients to make incremental shifts to allocation targets generally every three to six months.
The strategy of LDI is perceived by Rocaton and other leaders in the space as being an intellectual challenge. “The qualitative underpinnings of LDI recommendations to buy long-duration bonds and how markets interact with liabilities is very nuanced,” Pellish asserts. “If you overlook specific risks, you can make a lot or lose a lot. Our job is to convey this to a group of professionals who don’t deal with these arcane details on a regular basis.”
The arcane details that Pellish refers to are largely calculating the degree of mismatch risk clients can afford, thereby dividing the portfolio into liability-hedging assets and return-seeking assets. The tough problem, or equation that Rocaton must solve, is to help plans obtain adequate returns to make the scheme affordable in the long-run, while also generating enough matching assets so that volatility falls within acceptable bounds. “Implementation involves a number of details and every detail is important,” Pellish asserts. “Because there is no perfect hedge for liabilities, even for plans which attempt to fully immunize—allocating 100% of assets to long bonds—implementation risks still need to be managed. For plans which continue to allocate meaningfully to equities, evaluating and managing equity market risk remains a significant issue.”
Derivatives then become the option for the largest plans, yet investment consultants largely advise clients to start with bonds. The general consensus among consultants: Derivatives should not be something clients take lightly, with the general rule of thumb being that plans smaller than $500 million should avoid the complexity of derivatives due to comparative lack of resources.
The transition to an LDI mindset involves a paradigm shift—a struggle, even—to encourage pension investors to think not of total return, but of return in relation to liabilities. Rocaton was born with that mindset engrained in the firm’s philosophy, and as volatility continues to threaten corporate schemes, the best in LDI will be consultants who think of themselves as risk managers rather than return maximizers.
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