Liability Benchmarking and Completion Management

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aiCIO: Can you give us a brief overview of liability benchmarking and how plan sponsors should be thinking about it?

Veerman: Traditionally, LDI portfolios have been managed against market-based benchmarks, which were not created explicitly to manage against liabilities. Using market-based benchmarks introduces unintentional duration and curve exposures relative to the liabilities. Liability benchmarking goes the next step, taking the plan’s specific cash flows and discounting them at an agreed-upon discount rate to determine the rate and credit spread duration profile of those liabilities. Managing the hedging portfolio against the explicit liability benchmark reduces funded status volatility and unintentional exposures.

aiCIO: What type of expertise is needed for this to work?

Veerman: Managing against an explicit liability benchmark requires a very different skillset than managing against traditional market benchmarks. Our solutions team is comprised of professionals from a variety of backgrounds, including quantitative risk management, portfolio management, strategic asset allocation, investment consulting, actuarial science, and banking. The team we have put in place brings the necessary skill sets to properly manage against liability benchmarks. That being said, systems cannot be overstated. In recent years we have made considerable investments in developing systems to explicitly manage these risks versus liabilities.

Ledford: I would add that LDI is a core focus for us firm-wide. We’ve built our US solutions business around pension risk management, and made significant investments in people and resources to manage against liability benchmarks properly.

aiCIO: How does one determine success or failure with your approach?

Ledford: We define success as managing overall funded status outcomes while reducing funded status volatility within the objective framework established by the plan sponsor. We measure our performance explicitly against our clients’ liability returns, attributing out component changes to the discount rate that we cannot control, such as defaults and downgrades, which we call “uninvestability”. Defaults and downgrades can negatively impact the value of assets, while the majority of uninvestability is caused by a rise in liability values as these higher-yielding bonds fall out of the index used to determine the discount rate. Therefore, a key goal of ours is to deliver sufficient active outperformance via asset allocation management and active fixed income capabilities to offset the uninvestable components of the liability benchmark return.

Veerman: The asset management industry has been built around outperforming market benchmarks. In our view, from a solutions perspective, LDI performance should be measured against a plan’s actual liability exposures and how active management decisions offset uninvestability.

aiCIO: What is Completion Management, and why should plan sponsors be thinking about it?

Ledford: Plans may choose to allocate assets to more than one manager for diversification. In this case, the plan can employ an LDI completion manager. This manager uses a custom hedging portfolio to incorporate aggregate asset exposures across managers to achieve plan-level hedging objectives versus the liabilities. Each third party manager can manage its portfolio to maximize return versus the relevant market benchmarks, while the completion manager is tasked with the overall hedge performance versus the liabilities.

aiCIO: Do the same skills for a good LDI manager apply to being a good completion manager?

Ledford: For the most part, that is correct. But in our view there are a couple of additional attributes that lead to a successful completion manager. Completion managers should not take significant duration or curve exposures within the completion portfolio, nor should they offset intentional duration or curve exposures of the other managers. Second, completion managers must have a strong solutions governance framework in place.

aiCIO: Are you seeing indications that sponsors are now approaching pension management differently?

Ledford: As funding status has improved, we have seen committees become more liability-focused. To the extent committees are changing their focus, the ability of LGIMA to deliver upon the liability return is key.

Veerman: Liability benchmarking consolidates all that we’ve learned about liability driven investing and objectives-based investing, and reduces the number of decisions a committee has to make while simplifying the manager evaluation process.