The Pillars of LDI

How customized LDI strategies are spreading to small corporate plans and ultimately, public plans.

Nuveen Asset Management aims to simplify the holistic LDI approach through three distinct investment “pillars”. David Wilson (Head of Institutional Solutions), Evan Inglis (Senior Actuary), Amy Luberto (Senior Analyst), and James Colon (Head of Managed Volatility Strategies) discuss how customized LDI strategies are spreading to small corporate plans and ultimately, public plans. Q: When we spoke briefly prior to meeting, we talked about Nuveen’s three pillars to liability-driven investing (LDI). How do they shape Nuveen’s de-risking philosophy? Dave Wilson: First and foremost, we believe in holistic plan risk management. We express that in terms of these three key pillars to accomplish those objectives: liability-driven investing, demographic-based investing, and managed volatility strategies. First, liability-driven investing is a well-adopted approach by corporate pension plans. When we think about LDI, we see many different approaches and also note that many of them are far too complex. LDI managers also tend to be focused on the large to mega-sized plans in the market, leaving thousands of smaller plans behind. So with these two observations in mind, we sought to develop a solution that provides a simple and effective hedge of plan sponsors’ liabilities and one that accommodates both early and late-stage de-riskers. Also, one that serves as an equally effective solution for smaller plans as it does for larger plans. This project started out more than a year ago when we aligned with Wilshire Analytics, the investment technology arm of Wilshire Associates and the team that produces the Wilshire 5000 and many other indexes. Wilshire developed a methodology decades ago for many of the major custodians and consulting firms in the US where they receive bond data from those clients via a double-blind submission process and provide performance and allocation analytics for them as a service. In the process, they realized they were receiving valuable bond data—data that represent bonds held in actively-managed strategies for institutional investors. So they’ve decided to aggregate this data and create what is now called the Wilshire Bond Index. Wilshire’s key differentiator is that the bonds in the index represent bonds held in actively-managed strategies on behalf of institutional investors, whereas the Barclays Aggregate Index represents bonds outstanding. Therefore, the Wilshire Bond Index is a better representation of the actively- managed bond market. We leveraged this universe of bonds and first created our own sub-universe. Specifically, we removed bonds rated triple-B and below, structured products and variable-rate debt and ultimately arrived at a sub-universe of single-A to triple-A corporate and taxable municipal bonds to best replicate movements in corporate pension liability discount curves. We then took this sub-universe and created “buckets” organized by maturity range, because if you think of a pension liability, it is not organized by duration, it is a series of future expected cash flows. The liability itself can be organized by maturity range. After many iterations, we ended up with four indexes: an intermediate 5-to-10 year corporate bond index, a long 10-to-20 year corporate bond index, a long 20-to-30 year corporate bond index, and a 20-plus year (ultra-long) STRIPS index. We argue that if you’re a “late-stage” de-risker with a plan that is either fully funded or overfunded and looking for a precise hedge of your liability, a combination of strategies managed against these four indexes will give you minimal tracking error against your liability. For an “early-stage” de-risker, typically a plan that is underfunded and has a balance of growth assets and hedging assets, we recommend using one of the longer-duration strategies to maximize duration and yield. For example, a plan that has a glide path and is now an early-stage de-risker but will eventually progress to late-stage, can simply invest in a strategy benchmarked against, say, Nuveen’s Long Corporate 20-30 Bond Index. Then, as the plan becomes better funded, the plan sponsor could add the other indexes and complete its hedging program. Q: Is this a better way to customize LDI programs? Wilson: It’s a way to customize—and do it without derivatives. The combination of these indexes is designed to be a simple and effective hedge of the liability, available to all plan sizes. Evan Inglis: One of the key things we’ve done is to take the long corporate bond universe and split it up into these two pieces: 10-to-20-year maturities and 20-to-30-year maturities. This allows for a lot more flexibility to align the cash flows of the assets with the cash flows of the pension plan. So when we take just the 20-to-30-year maturities, as Dave was saying, we can offer a strategy that has more duration as well as more yield. It’s really the simple act of splitting up the long-duration universe that creates additional flexibility and solutions with more yield and duration. Wilson: That’s the keyword here: Simple. The asset management community has done a great job making LDI too complex. LDI is really simply asset/liability management and we hope that our approach reflects that. Amy Luberto: We have a corporate pension client who is in the early stages of de-risking now. We currently manage a long government/credit mandate for them and act as their completion manager. We saw these indexes and the associated products as a good opportunity for them to move from the current strategy that they have now into Nuveen’s Long Corporate 20-30 Bond Strategy. As Evan and Dave both described, they will be getting more duration and more yield. The increased yield is appealing to them and also the fact that we don’t need to use derivatives is a big selling feature for them. Initially, this change is fairly subtle but as we look forward to the end game and always keeping that in mind, we can provide a more precise match along the curve simply and effectively across these four strategies that we created. Q: How would small- to mid-sized plans benefit from this approach? Wilson: While this solution very much applies to large plans, it puts small and mid-sized plans on the same playing field. The cost of implementing a customized LDI strategy for a $100 million plan is far greater than a plan that has more than a billion dollars. It’s been our mission to solve that problem. Smaller plans also feel more comfortable with not using derivatives and leverage. So if we could offer a solution that takes those issues off the table and improves their effectiveness—then we think we’ve done our job. Q: You also mentioned demographic-based investing. How is that different than LDI and who does it apply to?Inglis: The demographic-based approach is for any defined benefit pension plan and it’s really an approach that makes sense and arguably should have been applied all along for any pension plan—corporate or public. We tend to focus on it in the public plan world because their liabilities aren’t measured with market interest rates, so a typical LDI strategy, which is all about interest rate and credit spread sensitivity, doesn’t apply. The demographic-based approach aligns the plan’s investment risk with the liability and starts with the retirees. The retiree segment of the liability is a very predictable cash flow stream because all the benefits have been calculated. Most of the benefits will be paid out in the next 10 or 20 years or so, and it’s possible to match the cash flows very effectively. This portion of the liability aligns very well with fixed income. However, the expected payments of the active population are uncertain and far out in the future. Their benefits haven’t been calculated yet because they will still get pay increases during their careers. You also don’t know when they’re going to retire. A demographic-based investing approach would align these uncertain cash flows with growth assets that also aren’t as predictable. So it’s really about aligning your growth assets with your obligations further out in the future and aligning your predictable asset cash flows with your predictable payment—similar to a target date fund that focuses on income. As the payment requirements get closer and closer, you start to focus more on that income and begin to move your assets into fixed income to provide the cash flow stream that you need to make the payments. It’s a very basic and intuitive approach. When we talk to people about the concept, they identify with it and understand it. Again, in the public plan world, you don’t need to get into matching duration. Luberto: We recently created a “functional” portfolio for one of our public pension clients. We first focused on the fixed income portion of their portfolio and transformed it into a liability-aware fixed income allocation. So, instead of a traditional total return fixed income strategy, we are specifically looking to match the near-term payments in a graduated fashion. For example, we plan to match 100% of the year one cash flows, 75% of years two through four and 50% of years five to seven. We’ll maintain this hedging percentage over time to make sure that we always have the highest likelihood that the near-term liability payments are going to be made without having to liquidate assets and without sacrificing the portfolio’s expected rate of return. Inglis: It’s kind of like a glide path—the fixed income allocation increases as the payment gets closer. Wilson: At their cores, public pensions and corporate pensions are the same. What makes them different is how their liabilities are valued as well as the surrounding regulatory environment. A corporate plan that is de-risking cares about matching duration and credit spread volatility to the liability. Public plans care more about meeting near-term benefit payments. Inglis: Another situation where this solution works well is for cash balance plans because the active cash balance liability is different from the liability for retirees. Most cash balance plans have retirees with a traditional pension liability, so we need a very different type of portfolio for the actives versus the retirees. By splitting up the different demographic groups and creating independent portfolios we get portfolios with the right kind of risk for each group. Another way the demographic-based approach can add value is by helping corporate plans to start aligning their assets with liabilities, but without worrying about whether interest rates are going up. So many plan sponsors are concerned about the potential effect of rising rates on a long duration LDI strategy. But the demographic-based approach does not necessarily extend duration because it initially focuses on matching the near-term cash flows for retirees. Q: Let’s talk about the third pillar of volatility management and derivative solutions. How do you address the return-seeking side of the portfolio? Wilson: If you think about partially executed LDI solutions, consider a plan that is 80% funded, with a 60/40 portfolio. The plan is an early-stage de-risker and extends the duration of its fixed income portfolio. Step one completed. When you look at how much they’ve altered their risk profile against their liability, the additional duration only has an incremental effect on overall risk. In fact, equity risk is still the dominant source of risk in that portfolio. This is where our risk-based strategies come in. James Colon: As Dave alluded to, so much of a pension plan’s investment risk resides in the equity allocation. It’s not just interest rate risk or credit spread risk that matters. So we’ve spoken to plan sponsors about extending their risk management programs to move beyond simply interest-rate hedging and to start looking at how they can actually manage the other components of risk inside their portfolio. We’ve designed overlay strategies that aim to manage to a specific risk target without disrupting the underlying investment managers. These strategies complement the LDI allocation. Wilson: On one hand, we’re looking to deliver a simple and effective de-risking solution with our indexes. But for plans that still have a meaningfully-sized return–seeking portfolios, what are the tools that we can employ to stabilize their risk profile? The blunt tool is more aggressive hedging of the liability. But many plans are just not in the position to do that at this point. Luberto: For example, we have another corporate pension client that is quite well funded at the moment and are further along in their de-risking glide path—but they still have 50% of their exposure in global equities. We weren’t comfortable with the amount of risk that this exposure brings to the plan. Our recommendation was to cut the equity exposure in half and move that portion to liability-matching bonds. But since they don’t want to completely give up the growth potential of the portfolio, we decided to implement an overlay strategy using equity index options on top of a portion of their hedging assets. This would allow them to take controlled equity risk with the goal of keeping up with—and hopefully outpacing—the growth of their liabilities. Colon: So for a plan sponsor that has a decent amount of exposure to equities and is looking to manage this risk, we first look through to their underlying benchmarks. We identify liquid derivatives contracts that we can use to manage the volatility of the equity strategy. We want to specifically manage the systematic risk. We don’t want to hedge away the active management component of the underlying manager. We then make short-term volatility forecasts for each of the exposures. Based on those forecasts, we will increase or decrease the amount of equity beta exposure in the portfolio. For the most part, it’s actually a pretty straightforward strategy. We’re just making short-term volatility forecasts and adjusting our market exposure to keep their overall volatility at the target level. Q: In closing, it seems that most of what you do is liability-focused. Is that an accurate statement? Wilson: If there’s one thing that aligns all of our thinking within our solutions team, it’s considering your assets in relation to a goal that you have—an investment goal or an obligation. You can turn almost any investment objective into a liability and our three risk-based pillars help us deliver on our objectives.