Historically low interest rates have made the decision to move to liability-driven investing (LDI) a tough one. At a time when many pension funds are looking for ways to bridge funding gaps, fixed income assets aren’t able to deliver the required returns to maintain plans at a reasonable cost. So, what are the alternatives? There are many, according to Michael Reid, senior strategist, pension solutions, Manulife Asset Management. During his presentation, “Enhanced LDI For a Low Rate World,” he encouraged plan sponsors to think carefully about what role fixed income is playing in their portfolios.
“LDI requires a different view of risk from an asset allocation perspective,” he noted. “You need to consider the correlations with liabilities, rather than simply from the perspective of risk and reward.” In that case, he added, the purpose of fixed income shouldn’t be for diversification – it should be as a liability matching asset, in others words a hedging strategy.
As Reid explained, there is limited scope for yield enhancement in the traditional long-term fixed income universe and duration calls may impact the hedging strategy. At the same time, funds need to be aware of unintended hedge ratio mismatches when making strategic asset allocations to other asset classes in the search for additional returns.
One approach Reid suggested is to take an “insurer” approach – create an an outcome-oriented annuity-like portfolio that incorporates other asset classes within the hedging portfolio, using a customized LDI benchmark and linking the hedge ratio to sponsor risk tolerance, with appropriate trigger points based on funded status.
Beyond bonds
Plan sponsors in need of addition yield should understand that de-risking can mean more than loading up on long bonds, Reid explained. Real assets, such as real estate and infrastructure, can be used instead. These asset classes can help plan sponsors meet a range of needs – specifically, real assets can provide an inflation hedge and predictable income, along with the possibility of higher expected returns.
Reid explained that the asset allocation decision for real assets needs to be approached from a different perspective than other asset classes.
“The traditional mean-variance optimization model may not be suitable for real asset allocation decisions,” he added. Rather, real assets should be built into a portfolio based on characteristics of the specific mandate being looked at, incorporating expected cash flow and the structure of the opportunity instead of simply looking at correlations of the asset class in general. Further, certain real assets may have different characteristics over different time periods and economic environments.
Ultimately, for plan sponsors seeking additional returns from their hedging portfolio, Reid had several final takeaways – first, clearly differentiate between strategic and tactical by “linking strategic decisions to your risk appetite or long-term return needs.” When using non-core fixed income assets, consider delegating tactical decisions to active multi-sector fixed income managers in order to capture opportunities from interest rate volatility. Finally, consider integrating real assets into the hedging portfolio.