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aiCIO: How are derivatives being employed for LDI programs right now?
Andrews: We are working with plans to incorporate derivatives into LDI programs to reduce risk in a variety of ways. Derivatives provide an extremely efficient tool to mitigate overall funded status volatility and shape funded status outcomes to meet plan objectives. We use derivatives to hedge downside equity and interest rate risk, release inexpensive funding from passive index equity exposures, monetize decisions that have already been made, and increase precision within liability hedging portfolios.
aiCIO: What strategies do you employ when using derivatives in your LDI portfolios?
Ledford: There are two key ways we utilize derivatives. The first is as an efficient hedging tool to manage against plan liability exposures. For example, we use Treasury futures in our interest rate hedging portfolios to target specific hedge ratios across the curve. Using futures provides capital efficiency and allows us to achieve a higher level of precision to effectively hedge the specific duration profile of plan liabilities.
The other way we utilize derivatives is to shape outcomes. LDI has gained significantly in popularity in recent years because pensions present an asymmetric exposure. Once a plan gets beyond a certain level of funded status, plan sponsors have limited use for additional upside in the assets, but retain dollar-for-dollar exposure to losses. Derivatives can be incorporated to help the plan benefit from this asymmetry. For example, a plan can sell unnecessary upside in rates or equities beyond levels needed to attain a fully funded or targeted overfunded status to purchase downside rate or equity protection, which helps the sponsor better protect their current funded status.
aiCIO: Is there any one type of derivative that an investment committee can get comfortable with if they are apprehensive—a gateway derivative?
Andrews: In a pension risk context, Treasury futures are typically the derivatives plans use first, because they are a capital efficient way to fill in the duration gaps of a physical bond portfolio. As plans get more comfortable with derivatives, they begin to use equity options and “swaptions” to move beyond just hedging to ultimately shape funded status outcomes. We work closely with plan sponsors and consultants to provide extensive derivatives education to help investment committees understand how derivatives can be used effectively to manage plan risks.
aiCIO: How do you see the use of derivatives for LDI evolving?
Andrews: We are working with several plans to implement a more active approach to managing derivative portfolios, particularly with equity options and swaptions. As long-term market hedgers with exposure asymmetry and significant collateral portfolios, pensions are uniquely positioned to benefit from short-term market dislocations. A big part of our evolving LDI derivatives framework is implementing derivative strategies structured to meet strategic plan objectives while benefiting from these opportunities. Maximizing these opportunities often requires a more active approach with some level of predetermined manager discretion, as markets often move faster than plans can react. We work closely with plan sponsors and consultants to develop the overall strategy and level of manager discretion that strikes the right balance to meet the overall plan objectives.
Ledford: We have seen active derivative strategies become more popular in the UK, and we think that plan sponsors in the US, as they get more comfortable with derivatives, will have a similar appetite for these types of strategies.
aiCIO: If this is the progression of LDI, it seems there are so few firms that are ready to invest in that infrastructure, including human capital. That should be a differentiator.
Ledford: That is absolutely correct. We have made significant investments in both people and system infrastructure to provide these pension risk management offerings to our clients. There are other firms that have good people and systems that are potentially capable of providing these types of strategies. However, the real question is: If pension risk management is not a primary business for these firms, are they willing to make the necessary investments to develop and implement these strategies appropriately? That’s a big question going forward.
Plan situation and objective
• Plan assets of $1bn allocated to equities (60%) and fixed income (40%) with a 25% interest rate hedge ratio
• Plan liability of $1.25bn with ~12 year duration profile and 80% funded status
• Plan has significant downside exposure to rates and equities
• Plan sponsor objective is to shape the funded status outcomes and minimize volatility across equity, interest rate, and credit spread risks
• Minimizing funded status volatility is key due to large plan size relative to company market capitalization
LGIMA solution
1 Replace $200mm of cash equity portfolio with total return swaps
2 Target 60% interest rate hedge and 15% credit spread hedge vs. liabilities utilizing a mix of physical Treasuries, Treasury futures, and long duration credit
3 Sell 3-year payer swaptions to commit to increasing hedge ratio to 80% at higher pre-determined rate levels (ATMF +50 bps) and raise a premium of $12mm
4 Allocate premium from the payer swaption sale to purchase 3-year 95-75 put spread protection on $200mm of equity portfolio
Strategy benefits the plan when the plan needs it most (scenarios in which rates and equity markets are down).
