Despite the low interest rate environment, it still makes sense for defined benefit pension plan sponsors to adopt a liability-driven investment strategy, said Serge Lapierre, global head of LDI at Manulife Investment Management, during a webinar it sponsored on Monday.
LDI investing is a risk management framework, he noted. “It’s not an asset class or a strategy that you get in or out [of] depending on market conditions; it’s really something that’s fundamental to the management of your pension plan.”
Further, LDI is for all types of plans, whether they’re closed or open. As cases in point, two very different pension plan sponsors — Nav Canada Corp. and Goodyear Canada Inc. — co-presented during the webinar, sharing their journeys in implementing LDI strategies.
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Nav Canada has an open DB plan with about $6.5 billion in assets under management that’s fully funded on a going-concern basis. “Our LDI approach was first implemented in 2009 following the impact of the global financial crisis on the funded status of the plan,” said Donna Mathieu, the civil air navigation services company’s chief investment officer.
“We realized then the limitations of having an absolute-return objective for the fund with no tie to how the liabilities were moving. We identified the need to manage the size and volatility of cash pension contributions that the company would be required to make due largely to the relative size of the plan versus the size of the company. And we knew it was important to maintain an appropriate balance between managing both going-concern and solvency funding.”
Prior to moving to LDI, Nav Canada’s asset mix was broadly 50 per cent equity and real assets and 50 per cent universe bonds. Over the past 10 years, it has gradually moved to a return-seeking allocation for 72 per cent of assets. The other 28 per cent of its portfolio is allocated to liability hedging and it has leverage of 28 per cent. “The intent was to reduce the interest rate and inflation risk mismatch between our assets and our liabilities, while using leverage to enable us to maintain a large liability hedge, while maintaining a healthy weight to return-seeking assets,” she said.
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Meanwhile, Goodyear Canada’s pension plans, which have about $900 million in assets under management, have been closed to new members since 2015. Currently, they have about 900 active members still accruing benefits and 2,500 retirees.
Goodyear began its de-risking journey in 2005 and implemented a custom LDI approach in 2011. “In the last two weeks of 2004, there was a significant drop in [10-year Government of Canada bonds] and that caused us to have to make some significant explanations to [the global] corporate finance [team],” said Thak Bhola, the organization’s manager of pension fund administration, noting the organization’s journey has been all about managing contribution volatility, especially arising from solvency rules and expense volatility association with U.S. generally accepted accounting principles.
In 2004, Goodyear Canada’s pension plans had a traditional allocation of 60/40 to equities and bonds, respectively. In 2007, it moved to 40 per cent equity, 30 per cent universe bonds and 30 per cent long bonds. And now, all of its union plans are 100 per cent in custom LDI strategies, while its non-union plan is 90 per cent in a custom LDI strategy and the other 10 per cent in global equity.
“Throughout our journey, one of the things we did from 2011 to 2020 with . . . our custom LDI managers, we’ve actually given them more flexibility over time,” said Bhola. “We’ve increased credit, we’ve introduced global credit [and] derivatives and we’ve replaced Canadian equity completely with global equity and now we’re looking at alternatives.”
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Even with low interest rates, LDI strategies can be helpful because interest rate risk is unrewarded, said Lapierre, noting plan sponsors should avoid looking at their investments in isolation. It’s important for an entire portfolio to earn a return that’s higher than the discount rate on the liabilities, he added.
“As long as you are able to achieve that, it makes sense to invest a portion of your assets in liability-matching bonds because you’re reducing the risk on one hand, in terms of interest rate risk, but at the same time, if you’re able to earn a positive risk premium over and above liabilities, you’re able to make up for [the] underfunded situation you’re in.”
In 2007, the hedge ratio of Goodyear Canada’s pension plans was 15 per cent and the 30-year bond yield was 4.1 per cent, said Bhola. In 2013, after it had introduced its LDI strategy, the hedge ratio was 65 per cent and the 30-year bond yield was around 3.2 per cent. “At that time, a combination of both contributions, as well as investment performance, helped us reduce our solvency deficit from the 2007 level number in dollar terms by 58 per cent. As well, . . . we were able to reduce our contributions by 35 per cent. In 2019, again we saw a reduction of our solvency deficit from 2013 by 10 per cent in dollar terms and contributions by 44 per cent. That’s significant.”
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Interest rates were definitely a consideration when moving toward LDI, said Mathieu. “I think we’ve all been saying that rates can’t get any lower and they have over a long period of time and they may stay low for an extended period of time from now. Our main focus was risk management and not return — to reduce the volatility of assets versus the liabilities. So the low interest rate environment is more a consideration for us within our return-seeking allocation than it is with respect to our liability-hedging allocation.”
In the current economic climate, which is still ravaged by the coronavirus, an LDI strategy has helped both pension plan sponsors. “. . . The high return of our liability-hedging assets year to date has been really valuable in reducing the gap between the growth of our solvency liabilities this year due to the significant decline in yields and the growth of assets,” she noted. “So it’s definitely doing its job in reducing the volatility between the assets and the liabilities.”