Liability Driven Investing - LDI Overview

Our Philosophy

• We strive to avoid downside volatility while sustaining or improving funded status
• We focus on real world risks to provide appropriate solutions for each client
• We believe that active management is essential

Our Experience

• Began managing custom LDI solutions in 1989
• Management capabilities include standard and custom benchmarks, creating overlay solutions and managing directly against liabilities
• Proprietary LDI Optimizer Model
• Dedicated Pension Solutions Team with over 23 years average experience
• Over 10 years of extensive LDI research experience

Key LDI Considerations

• Bonds Are the Low-Risk Solution

  Asset risks change when measured against the liabilities of a pension plan. Traditional total return investors have been conditioned to seek compensation for bearing asset volatility risk. However, for pension sponsors the relevant risk metric is funded-balance volatility. Because a pension sponsor’s focus is on investing to fulfill pension obligations, and because the valuations of those liabilities vary independently of most asset returns, DB plans face different risks from other investors. Liability valuations are highly sensitive to interest rates thus bonds, not cash, are the low-risk asset class.

• Funded Status Risks Cannot Be Eliminated

  Funded status volatility can be controlled but it cannot be completely eliminated because there is no asset that will behave exactly like the liabilities. Residual risk will always exist due to actuarial adjustments, survivor bias, and investments risks.

  The formulas to determine a plan’s projected liability stream are periodically updated with currently available actuarial estimates. These non-market related factors such as changes in benefit formulas or updates in longevity and inflation assumptions make the liabilities a moving target. Survivor bias refers to the fact that pension liabilities are discounted with the yield of corporate bonds but they possess the credit quality of a risk-free asset. Liabilities, unlike assets, are therefore immune from credit events. Investment risks refer to the limited assets that are investable (i.e. zero-coupon corporate bonds and bonds beyond 30 years to maturity either do not exist or are not available in size).

  For all these reasons, funded status volatility cannot be reduced below a barrier level. Plan sponsors should realize that beyond a certain point, further customization of their liability hedging assets will yield diminishing marginal returns from a volatility reduction perspective.

• The Path Matters

  Funded status volatility, often thought of as tracking error, is only one measure of risk that plan sponsors need to be mindful of. Because risk is multi-dimensional, plan sponsors should also be cognizant of other non-desirable outcomes such as funded status drawdowns. Cyclically sensitive companies should be extra thoughtful of the business environment in which drawdowns may occur as their pensions might require additional contributions during an inopportune time. If additional contributions are not available to shore up the plan, the need to continuously fund benefit payments can leave funded status permanently depleted even if asset returns eventually catch up. Plan sponsors therefore need to think beyond tracking error and realize that the journey can influence the destination.

• Active Management Is Essential

  As mentioned earlier, pension liabilities have market related sensitivities similar to that of bonds, but not exactly like those of bonds. In addition to being susceptible to non-market related issues (i.e. actuarial adjustments), liability valuations are immune from credit events. Liability valuations benefit from the yield of corporate bonds but possess the credit quality of US Treasuries.

  These factors present a high hurdle for plan assets to overcome. Passive fixed-income strategies do not offer the flexibility to avoid slippage in funded status. Active management of the liability hedging portfolio is critical to keep with the liabilities.