Liability driven investing (LDI) is perhaps the predominant pension strategy in the U.S. corporate pension plan landscape. Approximately half the pension plans in the U.S. invest 50% or more of their pension portfolios in a LDI oriented fixed income allocation, with total commitments estimated at almost $3.5 trillion dollars. LDI has historically provided a range of benefits to pension plan sponsors, including:
- Liability hedge for accounting purposes
- Liability hedge for contribution purposes
- Protection at high-funded levels given asymmetry of risk/return – if you're 100% funded, it is less advantageous to gain 10% funding than to lose 10% funding
- Reduced need for equity returns and associated risk at high-funded levels, given level of assets in hand relative to liabilities
- Focuses asset management on liability mindset and targeted restrictive use of pension assets
LDI strategies come with some drawbacks. Bonds have historically had lower returns than equities, so an LDI-heavy portfolio will carry a lower expected investment return. Large LDI allocations reduce the sensitivity of the plan to changes in interest rates, minimizing the impact of changing interest rates on plan funded status, thus constraining the ability of poorly-funded plans to improve their funded position. Several factors have typically determined the level and pace of LDI implementation with plan sponsor portfolios. Key drivers include relative size of liability and value of liability hedge in a comprehensive risk management framework, funded status of the plan, and alternative or opportunity cost of funds required.
Three considerations for LDI are considerably different in today’s market.
1. At very low yields, LDI today offers relatively less downside protection.
In the recent past, as shown below, we have experienced rates falling from over 8% to under 3%. In this environment, LDI has provided both strong absolute returns and significant funded status protection. A decline of this magnitude will not be repeated from this point forward, barring significantly negative rates.
2. Returns received from holding the bonds are now a drag on expected returns in today’s low yield environment.
This impacts both the asset pool (lower compounded returns to offset future obligations) and potentially the plan’s expected return on asset assumption used for pension expense purposes. LDI currently offers low yields, less downside protection, and interest rate risk should rates rise. It does offers interest rate risk protection should rates fall further, however given the current historically low yield environment that protection cannot be to the same extent we have seen in the recent past.
3. The passage of the American Rescue Plan and the Emergency Pension Plan Relief Act.
This round of pension relief extends the elevation of the interest rates used to measure plan liability for minimum required contributions higher than current rates and extends the time period over which plans are required to fund their deficits. Combined, the higher rates and longer deficit amortization period extend the amount of time a plan is able to invest plan assets before mandatory funding is required. As with all investments, an extension of time horizon typically lends itself to an increase in volatility tolerability in exchange for seeking higher return. Pension relief serves as a volatility dampener in and of itself, and exonerates the investments to provide all volatility dampening. Further, the investments can independently take on more volatility over time with this time horizon extension.
Extending the time horizon reduces the range of potential investment outcomes. As time extends, the law of large numbers drives long-term returns toward their expected values. A higher expected return (less LDI) portfolio outperforms with more certainty the longer the time horizon. This can be seen historically if you evaluate stocks vs. bonds broadly. Bonds can outperform in shorter time periods, but as you lengthen the time horizon, stocks always outperform. If a plan sponsor’s goal is to contribute plan minimums over a long time horizon, this would lead us to increase the expected return of the portfolio via equities and alternative investments, reduce LDI, thereby increasing expected asset return to optimize use of plan assets over time to offset future liabilities. For underfunded plans, this allows a return seeking portfolio to outperform a LDI portfolio even in some poor scenarios. The lower LDI portfolios have time to overcome temporary volatility and outperform LDI over time.
To seek optimal balance for risk assets vs. LDI, we recommend determining required returns for the plan based on current assets and benefit payment stream, projecting contributions and funded status over the plan sponsor’s time horizon for the plan, and modeling various levels of LDI in the portfolio to determine optimal outcomes versus plan sponsor risk tolerance levels. This is in line with how we have arrived at LDI recommendations in the past, however, we have seen with pension relief, the higher risk asset portfolios tend to perform better than in the past, and sometimes outperform even in downside projections due to the longer time horizon’s ability for return to matter more than it has in the past. Depending on the time horizon, this potentially shifts portfolios from LDI into additional risk assets.
What’s the appropriate strategy?
The changes outlined above may suggest changes in plan strategy. Certainly if evaluated in isolation, certain goals and objectives may not include an LDI allocation. In order to minimize long-term contributions, limited to no LDI may be appropriate in the current environment for lower funded plans. If year-to-year funded status volatility is an ongoing concern, LDI remains a potential solution.
However, plan sponsors have traditionally pursued multiple goals in managing the pension plans and several measures of progress. Those goals often may conflict – for example, improving funded status while minimizing contributions. LDI clearly is not dead – if a plan was 100% funded and fully hedged, a plan sponsor is unlikely to consider removing it. Plan sponsors will need to prioritize these goals more clearly and evaluate the trade-offs associated with each approach. Plan sponsors manage pensions to their specific goals and objectives. Our conclusion is to carefully focus on those goals that are most critical, and model various LDI exposures and the impact it has on future contributions, expense and funded status to see optimal level to meet those priorities.
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Information provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company.
Investing involves risk including possible loss of principal. There can be no assurance goals will be met nor that risk can be managed successfully.
Liability-driven investing primarily slates toward gaining enough assets to cover all current and future liabilities. A glide path determines how the asset allocation mix changes as the target date approaches. Beta is a measure of volatility in relation to the overall market. A non-directional hedge aims to generate a stable return regardless of market performance. DB providers can offload some or all of the plan’s risk through strategies such as pension risk transfers (e.g., retirement income liabilities to former employee beneficiaries).
This material represents an assessment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.