LDI: Back to Basics

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Is it really that complicated? Maybe it’s time to go back to basics

In September 2013, the funded status of the 100 largest U.S. corporate pension plans rose to 91.4% as measured by the Milliman 100 Pension Funding Index, the highest reading since October 2008. As U.S. equity markets continue strong performances, many plan sponsors are turning to de-risking strategies to lock in these gains. According to SEI’s 7th annual global Liability Driven Investing (LDI) poll, about three-quarters of U.S. plan sponsors are currently using or are planning to implement an LDI strategy. An LDI approach can indeed help control funded status and cash-contribution volatility while protecting the future assets of a pension plan, but implementation, active management and benchmarking can make or break a successful strategy. 

Step 1: Determining the amount and timing for a de-risking or LDI strategy

Most organizations have established or considered some form of glidepath strategy. This strategy can be called many things (journey planning, dynamic de-risking), but it is basically an active approach to asset allocation. It involves setting acceptable levels of risk to portfolios and establishing key trigger points to shed risk, or de-risk, as the plan moves toward a fully funded status.

Why not 100% LDI?

A glidepath strategy starts by evaluating the plan’s current funded status, its future needs and objectives, and the timeline for reaching these goals. When creating a glidepath, a plan sponsor first needs to set the plan’s funded target. This will help determine when the plan can de-risk exclusively through an allocation to fixed-income products. In setting the funded target, plan sponsors must also calculate enough return to overcome any plan expenses, actuarial estimation errors, or a possible yield pickup on liabilities. It may also include an estimate for the premium needed to terminate or annuitize the plan.

The mistaken belief that a 100%-funded plan should be 100% invested in fixed income or matching assets is generally caused by the non-economic construction of the liability discount rate. A possible yield pickup occurs because the rate used to discount the liabilities will almost surely be different from the yield on the bonds in which the plan is invested. In the U.S., plan sponsors of defined benefit plans must use a high-quality (AA or better), corporate bond spot curve to determine plan liabilities. Most plans will invest in a broad universe of bonds, including Treasurys, as well as lower-quality instruments to implement the LDI strategy. As a result, there will likely be a difference in the yield the asset portfolio is realizing relative to the discount rate of the liabilities.

Once the funded target is set, the next step is to determine the de-risking timeline and the corresponding contributions needed along the way. Many plan sponsors have made long-term decisions around freezing accruals or terminating the pension plan that may dictate the de-risking timeline. In those instances, many sponsors are implementing more aggressive de-risking timelines. But clearly, the trade-off between time and return/contributions will impact the aggressiveness of the de-risking strategy and the proportions allocated to LDI.

Impact of required contributions and benefit payments

Cash contributions to help fund the pension plan are having a direct impact on corporate balance sheets and finances. Developing a glidepath strategy can also help control contributions by creating a strategic schedule that positively increases contribution predictability over time. In setting the asset allocation, it’s important to remember that federal funding rules will require contributions. It would be unwise to disregard the infusion that the plan will be required to make under these rules, which can be thought of as return from the plan’s perspective. Therefore, to move to the next targeted, funded ratio, most plans can afford to take on less risk than is currently being implemented.

A naïve approach to developing a glidepath strategy would be to look at the funded ratio of the plan and set the risk based on
that factor alone. But the depletion ratio is also a critical component in setting a de-risking strategy. The depletion ratio is simply the erosion of an underfunded plan’s funded status due to benefit payments.

For example, a plan with $60 million in assets and $100 million in liabilities at the beginning of the year (i.e., 60% funded) that expects to pay $5 million in benefit payments will erode its funded ratio by 2.1% over the next year. This happens because the benefits payments, while the same for assets and liabilities, is a larger percentage of the lower asset than of the higher liability. And if the plan expects to pay out $15 million over the next year, the plan’s funded status will erode by 5.47%.

Some plan sponsors set glidepaths in linear, incremental changes that coincide with funding thresholds. Doing so without considering the depletion ratio fails to address the required return on assets needed to reach the next funding threshold. In other words, a linear solution is used to solve a nonlinear problem. The result will be greater volatility for the plan and a lower likelihood of achieving its goals. The required asset return needed to combat funded-status erosion can be determined by estimating the required benefits due over the next year.

By considering the depletion ratio and the funding-ratio target, a plan sponsor can determine how much total asset infusion the plan needs between asset return and required contributions to reach its funded status goal. Thereafter, the plan sponsor can subtract the amount of the contribution infusion and determine the exact amount of asset return it needs to move along the de-risking glidepath.

Active glidepath development and re-risking

A glidepath portfolio typically begins with a diversified allocation with moderate levels of risks. As the plan achieves increased funded status, a more conservative allocation is adopted with slight decreases in equity and moves towards lower volatility equity and fixed income. When a plan moves along its glidepath and hits a trigger, it’s critical that plan sponsors continue to assess current market conditions when considering asset allocation decisions. Credit spreads might not be appropriate for fixed-income allocations, so adding fixed income or staying in equities with the intent of changing might be a better fit.

Basically, glidepath allocations are economically dependent, and the expected return or volatility measured by the strategy may not be in line with the de-risking strategy. It may be that as markets and expectations move, the current glidepath or allocation strategy will not meet the plan’s current hurdle rate, and thus, either require more in contributions or longer periods of outperformance to catch up. This is why some plan sponsors consider not only de-risking, but also re-risking to be appropriate should markets and other factors cause the plan’s current allocation to fail to meet its current objectives set under different conditions.

Understanding the impact of the non-matching portfolio, as well as the components of the LDI mismatch, allows plan sponsors to decide where along the glidepath they should be, whether the glidepath should allow re-risking, and how much tracking error the LDI portfolio should target. As plan sponsors get closer to a fully matching strategy, the triggers of an LDI strategy should be managed in an active and customized way to properly match the liability stream for that particular plan.

Step 2: Understanding the relationship between an LDI strategy’s tracking error and the plan’s liabilities

Once plan sponsors have decided to start to de-risk, the allocation to LDI and its role in matching the liabilities can be confusing. First, it’s important to understand how the pension plan’s liabilities are calculated. An actuary begins by projecting what the benefit payment stream will look like over a given period of time. The actuary then calculates the present value of these future cash flows by discounting the benefit payment stream against a yield curve of high-quality corporate bonds (Chart 1). Because the discount rate ties the benefit payment stream to the performance of interest rates, the plan’s liabilities respond accordingly: when rates go down, liabilities go up, and vice versa.

The sensitivity of an asset to the movement of interest rates is known as the duration. For example, having a duration of “10” means that for every 1% change in interest rates, the asset value will change by 10%. In an LDI strategy, duration looks at the benefit payment streams and calculates the sensitivity of each stream to the discount rates. It makes sense that a benefit payment that is further in the future will be more sensitive to a change in interest rates. This calculation would be fairly simple if there were only one payment stream; however, a pension plan has many payment streams, all with different durations. The effective duration of a pension plan is a combination of all of these benefit payments discounted back to the present. To do this efficiently, the present value sensitivities are aggregated into key-rate duration buckets.

Let’s look at an example of how liabilities and durations are calculated. In Chart 2, the pension plan is 100% funded and uses a 100% Core Fixed-Income LDI implementation. Core Fixed Income has a duration of roughly four years, and the plan has a duration of around 13 years. In this example, you can see that Core Fixed Income provides good coverage and closely matches the liability in the early years, but there are significant gaps beginning with year seven. As a result, the plan has an effective hedge of 32.8% and a funded-ratio volatility of 9.4%. This means that the 100%-funded plan, with all of its assets invested in Core Fixed Income, has an unpredictable and fairly volatile funded ratio of between 82.2%
and 112% on an annual basis.

Some plan sponsors try to address this mismatch by buying long-duration bonds, such as the Barclays Capital Long Government Credit Index or the Barclays Capital Long Corporate Index. As can be seen in Chart 3, adding long bonds would indeed improve the duration match, as the current liability duration is 13.4 years and the effective asset duration is 12.5 years, giving an effective hedge of 93.3%. But you can also see in this example that there are some mismatches, especially near the long end. This type of implementation is based upon public market benchmarks, not the unique benefit payment stream of the pension. If the money manager buys bonds that differ from the public market index, there will be tracking error, which will either yield alpha or lead to loss relative to the public market benchmark. The challenge is that the true benchmark is the pension plan’s distribution of key-rate durations, not the public market benchmark.

An effective LDI implementation would fill the remaining gaps. An overlay of U.S. Treasury STRIPS or interest rate swaps can help to create coverage across the entire curve as a result of their liquidity. In Chart 4, an overlay of STRIPS more closely matches the effective duration and also reduces funded-ratio volatility and the range in the funded-ratio confidence interval.

As you may have noticed in Chart 4, a diverse fixed-income strategy, coupled with an overlay of STRIPS, still does not guarantee a perfect hedge. In tough markets, the sample pension plan has a 92.8% funded ratio, but it’s only 103.9% in good times. So while a customized LDI implementation goes a long way to reduce the risk and volatility of the pension plan, there are still risks that remain due to the construction methodology of the liabilities discussed earlier. This is commonly known as “basis risk,” or the difference between what is used to build the discount rate and what is used in the LDI implementation.

The match to the liabilities is imperfect, and there has been a lot of research as to why the tracking error and benchmarking to the liability are likewise imperfect. So at best, the goal should be to understand the major factors impacting the tracking to the liabilities, and investments should be made so as to best minimize that risk. Plan sponsors should be cognizant that this mismatch is not solely dependent upon the liability, but due to the correlation and impact of the nonmatching portfolio as well.