5 steps to creating an LDI framework

Underwriting – Differences in the returns on the liability benchmark and the MRP highlight a very important point: an investment strategy typically cannot fully hedge (or immunize) the liabilities of a pension plan. There are a variety of reasons for this, including cash flow uncertainty due to salary increases and mortality experience, obligations that extend beyond the maturity of available bonds and other design features such as partial or capped inflation indexing. Underwriting risk represents benefit promises made by the trustees or plan sponsor that cannot be managed through capital markets and, hence, must be accepted and managed or alternatively eliminated through changes in benefits policy. Understanding and quantifying these risks help to clarify the role of investment policy.

Benchmark – Benchmark risk represents the potential for differences in the performance of the MRP and the policy portfolio adopted by the plan fiduciaries. The process of establishing an appropriate level of benchmark risk is at the heart of the LDI framework in that the investment policy is set with a direct line of sight to the benefits and funding policies. Many plan fiduciaries will accept benchmark risk with a view to increasing accrued benefits or reducing expected future cash contributions by earning incremental returns over the growth in liabilities. Ideally, the degree of benchmark risk would also be aligned with the ability and willingness to increase contributions or reduce benefits if realized performance falls short of expectations.

Tracking error – Tracking error risk represents investment implementation risks, including manager selection (individual manager performance) and tactical asset mix decisions relative to the policy benchmark.

An LDI framework involves setting investment objectives not in absolute terms but relative to liabilities. Virtually all investment strategies are designed around a policy benchmark (e.g., 50% equities, 40% fixed income, 10% real estate) with the belief that this strategy will generate higher returns than the growth in liabilities over the long term with an acceptable amount of risk.

However, the extended period over which equities and other theoretically higher-returning assets have now underperformed liability growth likely challenges expectations of what long term really means. Further, the advancing state of plan maturity and the market value focus by regulators and accounting standards each heightens the relevance and importance of short-term relative performance.

An LDI framework is also about measuring and monitoring the right thing. In many cases, plan fiduciaries have devoted a tremendous amount of time managing the performance of individual managers and paid far too little attention to how the policy benchmark was performing relative to pension plan liabilities. The past decade, or perhaps even the last quarter-century, shows the potential folly in these practices.

All of this is not to suggest that all plans have accepted unacceptable levels of investment risk. Again, LDI is a process for establishing appropriate risk levels and not necessarily about risk avoidance or minimization. The degree of risk in current policies may be entirely appropriate where trustees and plan sponsors, in hindsight, maintain that they have the ability and willingness to accept the risks associated with market conditions of the past decade. However, for plans facing unmanageable funding levels or benefits reductions, now may be an appropriate time to revisit investment strategy within an LDI framework. BC

Jim Cole is vice-president with Phillips, Hager & North Investment Management Ltd.
jcole@phn.com

> click here for a PDF version of this article

© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the July/August 2010 edition of BENEFITS CANADA magazine.