This question was posed at a recent conference where I spoke. It brought snickers from the crowd, but poignantly captures the widespread view that liability-driven investing lacks penetration, despite the fact that LDI has been around for awhile.
You've been hearing about it more now because of new regulatory and accounting rules on funding requirements and how a pension plan's funded status must be shown on the company's balance sheet. These rules - under the Pension Protection Act and FAS 158 - may lead to higher volatility of both a plan's funding requirements and the company's financials. LDI can help limit that volatility.
LDI is a strategy that considers a pension plan's liabilities when investing its assets. LDI is not a product. Rather, it frames risk and return relative to the movements of the liabilities. LDI does not necessarily mean lower returns. You can still seek higher returns by taking investment risk, even in an LDI strategy. And since it is only a different way to look at risk, LDI need not reduce risk, although it is the most common application.
Because traditional pension liabilities increase when interest rates go down, and the value of bonds do the same thing, LDI strategies usually incorporate bonds to control changes in the funded status. To minimize risk, an LDI strategy focuses on finding the right bonds to match the interest-rate sensitivity of the pension liability, matching the duration of the bonds with the liability stream.
With all of the compelling reasons for implementing LDI, why is adoption so slow? In a nutshell, the culprit is human nature. I posit that there are three probable reasons: inertia, betting on interest rates and peer comparisons. Understanding these counterproductive tendencies and how to overcome them can be integral to a pension plan's success.
Inertia: Sticking to the old way
The pension investment paradigm traditionally has been chasing returns rather than managing for pension risk (cost uncertainty), which is driven by changes in a plan's funded status. The new pension rules encourage closer liability matching, so the definition of risk and the efficient frontier has changed.
For instance, in the absolute or total return world, cash is the low-risk asset but also the lowest-returning asset on a long-term basis. Equities represent high risk and high return. Intermediate bonds are also a fairly efficient tradeoff between risk and return. Compared to intermediate bonds, long bonds introduce more volatility risk but carry only slightly higher return.
But for most traditional open plans, let's say, all that changes when considering the liability stream, which basically acts like a long bond. As rates rise, both the value of the liability and long bond drops, and when rates fall, their values rise.
Therefore, in the liability-efficient world, the least risky asset is not cash, but an asset that acts like the liability - namely, a long bond. (Interestingly, neither cash nor intermediate bonds are efficient here because they don't match the liability stream. Stocks, however, remain efficient by representing high return and high risk.)
This paradigm shift from the absolute-return world to the liability-efficient world has not widely occurred. Plan sponsors may fondly remember the "funding holidays" that often stretched for decades, when return-oriented strategies easily covered pension plan costs. The new rules mean those strategies can have a big impact on company financials and funding requirements. Do you want to live with that level of uncertainty in this environment?
PQ Corporation didn't. The Valley, Forge, Pa.-based global producer of silicate, zeolite and other performance materials chose to move to an LDI strategy about two years ago after deciding to freeze its pension plan.
"We had a strong understanding of the new rules and what they meant to our business, so moderating the volatility of our funded status was important to us," says Susan Olafson, PQ's director of benefits, compensation and HRIS. After initially implementing an extended-duration strategy and then moving to long-term corporates, the dynamic nature of the approach paid off, she said.
"When the market went bad, we did much better than had we stayed in our previous allocations, especially during the fourth quarter of 2008. Most important, substantially lengthening the duration of our bond portfolio allowed our asset values to move more closely in line with the value of our pension liability."
Betting on interest rates
Because interest rates seem low, many investment committees are leery of matching liabilities with long-dated bonds. They argue that rates ought to rise, which would mean a drop in bond prices, especially long bonds.
But as we know, betting on the direction of interest rates is a difficult proposition, especially given a pension plan's rate sensitivity and the difficulty of oversight by part-time investment committees.
If a committee views current rates as low, a process that gradually invests in better-matching bonds can move the portfolio toward risk control with less concern about market timing. Do you want to assume responsibility for maintaining a shorter bond position as a tactical bet?
Peer comparison
For years, consultants and others have cautioned sponsors against gauging their plans against peer plans on performance and asset mix. Peer comparison also creates a chicken-and-egg dilemma for implementing LDI: Few will do LDI because few are doing it.
Sticking close to what your peers are doing may be a mistake for a host of reasons: their liability, plan size, plan status (i.e., open or frozen), financial and business situation (i.e., cashflow, dependence on market cyclicality, and ownership structure) and corporate risk preference could be wholly different than yours. Doesn't it make sense to do what is best for your plan and company's unique circumstances?
Marcia Peters, director of risk management at consulting firm Portfolio Evaluations, also cautions against comparing your plan to those of a peer group. Instead, she said, focus more on a customized benchmark created to reflect your plan's unique asset mix and change in asset-to-liability valuation.
Overcoming these obstacles
This trio can be a powerful barrier to changing a portfolio. But action is needed, because the rules and markets have changed, and the 1990s aren't coming back.
Here are some logical steps for moving toward an LDI framework:
* Move from an absolute return world to a liability efficient world. Because the funding ratio has become more important than the portfolio's annual return, you need to look at risk differently.
* Avoid market timing. Gradual adoption of LDI is usually recommended - market timing is rarely advisable and moving gradually will minimize the risk of a decision that looks bad in hindsight.
* Refrain from comparing yourself to your peers. The overriding factors in your investment decisions should be the characteristics of your plan and company - not what your colleagues elsewhere are doing.
It's probably safe to say that with the market turmoil of 2008-2009, plan sponsors and investment committees want to avoid more surprises. While higher levels of risk may help improve current underfunded ratios, an understanding of LDI will help preserve future higher funded ratios.
It's likely that the risk you may perceive of moving to an LDI strategy is far lower than if you don't. Looking at LDI with a different lens may be all you need to get started.
Bosse, CFA, is a principal at Vanguard and a member of its investment strategy group. He consults with institutional investors on asset allocation and portfolio construction.
