Legends of LDI

LDI generally refers to any strategy in which asset investment decisions are taken in relation to a scheme’s liabilities rather than a combination of isolated asset benchmarks. In general, the Canadian DB marketplace lags significantly behind the early adopters of LDI in the European Union and the U.K., and slightly behind the U.S.

This is not to say that LDI has not been embraced in Canada, as a number of large DB plans have integrated such strategies into their overall investment approach. Yet despite the growing utilization of LDI, there is a wide spectrum of knowledge among Canadian plan sponsors on how to implement a liability-based investment policy within their portfolios.

This article focuses on demystifying the five most common misconceptions typically associated with LDI.

1. LDI is a one-size-fits-all strategy.

2. LDI is risk-free.

3. Derivatives make using LDI precarious.

4. Changing a plan’s existing allocation and investing within an LDI framework is too costly.

5. It is unwise to implement LDI when interest rates are so low.

1. LDI is a one-size-fits-all strategy.
A common misconception is that LDI is a product or a stand-alone fixed income strategy and that plan sponsors can simply dedicate a portion of the plan to LDI. However, LDI is more than just a single strategy. It is a risk framework that focuses on improving the risk efficiency of the plan in its entirety by aligning the exposures of the assets with those of the liabilities.

In most instances, LDI implementations do not consist solely of fixed income securities; they also include diversified growth-focused exposure that seeks to add excess return over the liabilities. The expectation is that this additional return will help reduce future contributions to the plan and also provide a buffer, should there be unexpected changes to the liabilities. Figure 1 provides a high-level overview of the options that plan sponsors can consider when setting investment policies.

At the far right of the spectrum, plan sponsors can choose to remove a significant amount of risk from the balance sheet by terminating and annuitizing the plan. Terminations, which reduce risk to the plan sponsor, are expensive and are not necessarily a readily available option for many plans—especially those that are underfunded.

At the far left is the traditional “total return” investment policy. While this has historically been the most widely accepted investment policy, volatility has had a dramatic impact on asset and liability durations, liability valuations and funding ratios. This is prompting plan sponsors and consultants to take another look at liability-matching investment options.

In between these two extremes is an assortment of different LDI strategies, including duration extension, hedging and growth, and cash flow match/immunization. Plan sponsors can stick to a single LDI strategy or create a combination of different strategies that fits their investment objectives and requirements. Within the LDI investment strategies, there is no one-size-fits-all approach, since each plan’s investment policy is unique.

2. LDI is risk-free.
There are many types of LDI, with varying levels of risk. LDI is a framework to help plan sponsors minimize risk. So, what are the risks that plan sponsors should consider?

The biggest factor that will affect the valuation of the liabilities is interest rate risk. Some of the tools used to hedge interest rate risk include government and corporate bonds, futures and/or swaps. How, and to what extent, these tools are used determines the amount of interest rate risk that is removed.

Next is equity risk. For those plans that implement a hedging and growth portfolio to enhance returns, this can be the largest remaining risk in the investment policy. Take, for example, a fully funded plan that incorporates a 100% interest rate hedge ratio, essentially removing all interest rate risk. The plan may then take a portion of the funds and invest them in domestic and international equity markets. While the interest rate risk is effectively removed, the growth portion of the pension fund is still vulnerable to fluctuations in equity markets, putting the funding ratio at risk.

Finally, aside from any market factors or investment policy decisions, actuary risk remains. This is defined as the risk that arises from the differential between actual cash payments to retirees and those projected by the actuary. There are a multitude of factors (e.g., length of retiree life, inflation) that will affect the funding ratio over time, and each is difficult to hedge. As every plan manager knows, predicting future liabilities is much more challenging than understanding the fund’s assets.

3. Derivatives make using LDI precarious.
While derivatives usually play an important role in LDI strategies, they are not required. Many plan sponsors are prohibited from using derivatives and/or leverage. It is important to remember that LDI is a risk framework, and there are many changes to investment policy that can help plans to better manage funding ratio volatility—none of which require derivatives or leverage.

The true success of a plan is its ability to meet future benefits payments. Plans that are prohibited from using derivatives can still reduce elements of interest rate and equity risk. Interest rate mismatch between asset and liabilities can be reduced by extending the duration of a plan’s existing fixed income allocation and/or increasing this allocation.

Plan sponsors can further reduce potential funding ratio volatility by diversifying the core growth portfolio away from domestic and international stocks. Hedge funds, real estate, private equity and commodities are all options to spread the risk away from an equity-heavy portfolio and decrease funding ratio volatility.

For plans that choose to use derivatives as part of an LDI strategy, the potential benefits of using derivatives can outweigh the potential risks of taking on counterparty exposure. First, the clear benefit of an overlay hedging strategy is that it provides asset duration exposure in a capital-efficient manner, meaning that plans can help to reduce overall interest rate risk without disrupting the existing asset allocation. Second, a closer look at counterparty exposure reveals that strong counterparty risk controls and collateral management can help reduce this risk so that it is essentially less than taking on corporate bond exposure.

4. Changing a plan’s existing allocation and investing under an LDI framework is too costly.
The “too costly” argument commonly refers to the decline in expected return as a plan reduces its exposure to growth securities and increases its exposure to fixed income. While lowering the expected return has the potential to increase future contributions, it is just one factor that influences the final investment policy within an LDI risk framework. As we move away from a total return investment policy, the importance of expected return is reduced as other factors play a more prominent role in the decision-making process.

Key to constructing LDI solutions is finding a balance between reducing funding ratio volatility, hedging interest rate exposure and meeting excess return objectives. In addition to expected return requirements, other major factors that affect investment policy include a plan’s liability structure (i.e., annuities at retirement, cash balance or hybrid), its current funding status, the financial strength of the plan sponsor, the plan’s size relative to the sponsoring organization, and the plan’s risk tolerance, time horizon and mandate constraints.

Understanding the factors that influence the decision to invest and the importance of each factor, as well as the trade-offs between different investment approaches, will help to ensure that an appropriate program is established and adjusted as plan preferences change over time.