The 2008 financial crisis jeopardized the funding ratio (i.e., the ratio of assets to liabilities) of most DB pension plans, forcing plan sponsors to inject money or cut benefit provisions—or both. Plan sponsors now want greater certainty about their funded status. That’s where liability driven investing (LDI) makes sense and why it will become a more important part of overall plan governance and management.
LDI is neither an investment product nor an investment strategy. Rather, it’s a process of co-ordinating a fund’s assets with its liabilities. The ultimate goal is to make sure that liabilities do not outgrow assets over the long term and that the funding ratio remains relatively stable in the short term. In this way, LDI is a risk management tool and not just an investment management alternative.
For most plan sponsors, the first big obstacle is getting started. Following is a step-by-step process on how to integrate LDI into your plan’s management and governance structure.
Step 1: Educate your stakeholders
To successfully introduce LDI, educating key governing stakeholders is essential. At each step, you will make critical decisions, and stakeholders need to be informed. You need an education program that occurs throughout the process, not simply at its inception, in order to make more efficient and effective decisions.
Your investment consultant, actuary, custodian and investment managers are instrumental in educating stakeholders, since each plays a different role in the LDI process and can offer different perspectives and experiences that provide valuable insight. Additionally, your service providers may already have education materials, saving you time and resources.
Your education program should build understanding in five principal areas:
- plan benefits and contributions, cash flows and how to determine their present values (plan liabilities);
- returns and risks offered by different asset classes and how they behave relative to plan liabilities;
- risk in the context of a pension plan and what it means to accept, mitigate or eliminate it;
- how funding, investment and benefits policies interact with one another; and
- what it means to manage a pension plan on a total balance sheet basis, looking concurrently at liabilities and assets.
Step 2: Understand your plan’s liabilities and objectives
Your plan’s long-term objective is to have sufficient assets to cover benefit payments. However, in the short term, the actuarial valuation results that drive plan funding could affect your LDI strategy.
Most pension plans have up to three different actuarial valuations—accounting (i.e., financial reporting), going concern and solvency—which could produce three different sets of liabilities and three separate funding ratios. With all of these alternatives vying for consideration, governing stakeholders need to carefully determine which valuation has the greatest influence on funding plan benefits in the short term. The liability resulting from the selected alternative becomes the base to which the LDI concept is applied. Since LDI is a dynamic process, you will need to revisit the impact regularly.
Step 3: Identify and evaluate plan risks
First, use broad groupings of risks, such as asset management, actuarial valuation, plan design, plan administration, plan demographics and the economy at large. Next, identify the key risks that directly affect your ability to meet the plan’s objectives. Then, assess the relative impact of these risks on your pension plan and your stakeholders’ tolerance for each. The asset liability management (ALM) study (Step 5) can test for risk tolerance.
Generally, you want to take risks for which you expect to be rewarded and avoid or reduce risks that carry little or no reward. “Macro” risks, such as economic depression, are difficult to mitigate. However, investment risks—such as equity market, credit and liquidity risks—offer potential reward, so you may want some exposure. The LDI strategy can also manage other risks, such as interest rate and inflation risks, that directly affect both assets and liabilities.
Understanding your risk exposures and tolerance leaves you better prepared for the ALM study and related decisions. It also helps you to maintain consistency with your plan objectives over time.
Step 4: Assess the flexibility of your funding policy
The risks in Step 3 affect your plan to different degrees, so it’s important to be aware of additional funding requirements under various scenarios. Your funding policy will help you to understand the financial constraints, as well as which risks you can mitigate by changing it.
Table 1 shows funding flexibility in different situations. Usually, when you have little funding flexibility, your capacity to bear risk is limited.
Step 5: Use an ALM study
The ALM study provides critical information for implementing LDI. It looks to answer the question, How do I determine how different adverse risk scenarios affect funding? and lets you consider plan assets and liabilities at the same time. Typically, the analysis uses an asset-liability model to forecast outcomes over 10 to 20 years. The study tests how various asset mixes affect the plan’s financial position, funding flexibility and risk exposures, as well as your tolerance around those risks.
There are many different forecasting models, and each has its merits. The model you choose must be able to forecast the key characteristics driving the plan’s governance, such as the funding ratio on a solvency and ongoing basis, required contribution and benefit accrual rates, and other factors such as indexation. While models are useful analytical tools, they cannot foretell the future; they simply forecast specific plan characteristics based on a set of assumptions. You will need to apply judgment to the ALM study results. Sensitivity testing on some of the assumptions used in the forecast model will add valuable insight.
In an LDI context, the ALM study’s primary output is the appropriate asset allocation between a liability-hedging portfolio and a return-generating portfolio that meets the fiduciaries’ objectives and risk tolerance. A liability-hedging portfolio has characteristics similar to the liabilities and seeks to move in tandem with the liabilities. A return-generating portfolio aims to grow faster than the liabilities, but it carries greater risk.
Step 6: Balance risk-taking and risk-reducing
When using an LDI strategy, you will first seek to minimize risk through a liability-hedging portfolio and then seek to obtain the highest returns from a return-generating portfolio within your risk tolerance. The blend is important. If you invest assets only in a liability-hedging portfolio, your fund will likely have long bonds and interest rate swaps. This will reduce most of the risk, but it also carries a high price: a substantial increase in the value of plan liabilities, given the ensuing reduction in the actuary’s valuation interest rate (to 3% or 3.5%, the current long-bond yield). Since that’s unacceptable for most pension plans, they need to accept more risk through a return-generating portfolio.
A typical liability-hedging portfolio focuses on Government of Canada bonds that match the size and timing of projected benefit payments. For additional returns, corporate or provincial bonds or even mortgages can replace a portion of the Canada bonds. Your plan’s market, credit and interest rate risks will increase, so it’s critical to consciously balance risk-taking with risk-reducing.
A return-generating portfolio may include public equities, alternative investments or even alpha strategies. When choosing from among these riskier asset classes, consider which ones behave similarly to your plan’s liabilities. For example, real estate, infrastructure and commodities may have a better positive correlation to liabilities than public equities; however, they also require greater understanding, time and resources to oversee and have longer investment time horizons. These are among the practical implementation considerations that you need to address, along with the risk-budgeting exercise, before you can determine the appropriate asset mix.
Once you set the right mix, you need to reflect it in the plan’s Statement of Investment Policies and Procedures (SIP&P). Since circumstances change, the SIP&P should allow the balance between the two portfolios to change dynamically, reducing risk-taking when the funding ratio improves and possibly adding risk-taking if it deteriorates.
Step 7: Monitor and review
When you decide to adopt an LDI strategy, you also need separate benchmarks for the liability-hedging and return-generating portfolios. For the former, an appropriate benchmark comprises Government of Canada zero-coupon bonds and other low-risk Canada bonds that replicate projected benefit cash flows as closely as possible. The return-generating portfolio can continue to use relevant market-related benchmarks (e.g., the S&P/TSX Composite Index for Canadian equities and the S&P 500 Index for U.S. equities).
Since the LDI process is not stagnant, there will be changes even from the outset. For example, on the liability side, your plan’s actual experience will differ from the demographic and economic assumptions used in the liability valuation, which means that you need to monitor it regularly. Additionally, due to coupon and principal payment dates, the liability-hedging portfolio will not exactly match the plan’s benefit cash flows.
Finally, as noted in Step 2, the valuation most influential to funding may change in the short term. Review your results regularly—and reassess your benchmarks and overall strategy—to mitigate long-term risks and achieve your plan’s broader objectives. This review and reassessment may also trigger other ALM studies: it’s reasonable to have a new ALM study every three to five years or following an important event, such as the 2008 financial crisis. While this is not a precise exercise, written rules (preferably within the SIP&P) will provide discipline to the governing stakeholders managing the plan.
Coupled with continuing market volatility, the financial crisis has prompted greater awareness of the risks embedded in pension plans. Implementing an LDI strategy is not a panacea, but it is a step toward addressing these risks.
For LDI to be successful, your governing stakeholders must be well educated and follow a thorough process, identifying all risks and ensuring that all avenues to mitigate them have been explored. You will not only emerge with a strategy for liability-hedging and return-generating portfolios but also create a dynamic strategy that adjusts according to markets and other factors.
Creating and customizing an LDI strategy can be complex. But it’s an important and worthwhile exercise to help ensure successful delivery of the promised benefits.
Louis Martel is managing director and chief client strategist with Greystone Managed Investments. louis.martel@greystone.ca