Summary paragraph: From aiCIO Magazine: Is there a better way to implement liability-driven investing?
To see this article in digital magazine format, click here (http://www.ai-ciodigital.com/ai-cio/2011spring?folio=58).
Technology abhors an early version. It took Apple's iPhone 12 months to go from its first form to its second (which, amazingly and ironically, was even more likely to drop calls than the first). Microsoft's flagship Windows product took less than two years in the mid-1980s to make the same leap. Television advertisements touting the latest handheld product frequently try to one-up each other by claiming that their recent invention is third, fourth, even fifth generation technology -- a claim true only if generations are being measured in Mayfly years, not human ones. Without much of a mental leap, this widespread technological habit can be compared quite directly with the humorous race by men's razor manufacturers to add yet another blade to their already weighty products.
Liability-driven investing (LDI) is not yet there. However, if LDI has evolved from its earlier days 15 years ago, talk of LDI - and how to overcome the central conundrum of when you most want to implement it, you can't, and when you can, you don't want to implement it -- is still very 1.0. Here is Version 2.0.
The permutation from LDI 1.0 to LDI 2.0 is, at its root, the change from convincing pension fund executives that liability-focused investing is an appropriate choice to convincing them that it is the only choice -- and that the accompanying increase in complexity is an unavoidable but manageable evolution. While the weight of the different factors driving this change varies by an observer's opinion, the factors themselves do not. They are, in no particular order, the global and mass closing of corporate defined benefit pension plans ("Because so many are being closed or terminated, more people are focused on their liabilities," says Jay Vivian, former Retirement Funds leader at IBM, and early adopter of LDI); the Pension Protection Act and the various equivalent European directives such as the Netherland's FTK regulations that mandate risk capital buffers above liabilities (Dutch funds being pioneers in the LDI space); and being burned twice in 10 years by crashing markets ("People, from institutions to retail investors, don't want to live through this for a third time," remarks Ray Kanner, current IBM Retirement chief).
Yet, worries persist that these lessons have not been learned well enough, and that too many CFOs still look at their pension fund liabilities tactically (i.e., through the prism of the markets) and not strategically, where the conclusion has to be immunization followed by termination. "People made 2008 and 2009 out to be a terrible coincidence that asset losses were followed by increases in liability valuation," says Rick Campbell, Investment Program Strategist at Northern Trust. "It's not. We should fully expect major equity losses to be followed by interest rate cuts. Fund executives need to remember, and plan as funded ratios improve to reduce equity exposure to protect these healthy funded ratios." The logical conclusion, then, is if one believes in the essentiality of liability-focused investing for corporate funds, then one should strike while the iron is hot -- and lock in a strategy or a strategic plan that will institutionalize a dedication to LDI.
First, the theory: According to Scott McDermott, Goldman Sachs Asset Management's Managing Director for Global Portfolio Solutions, "if you have risk you can't afford, you should hedge it. A lot of people can't afford to be less funded. There is no bell to ring to tell you when the right moment is. It's not always a welcome message, but it's mine." The logical result of this often-difficult discussion, he believes and promotes, is that glide-pathing a fund's way toward immunization is paramount, regardless of the current market environment and interest rates. "Rather than investing to achieve a large surplus, today's pension fiduciaries invest to avoid deep deficit," wrote McDermott and two other GSAM employees in an April 2010 white paper. 'The implication is that a pension plan's asset allocation needs to change as the plan's funded status changes." Using the concept of "surplus value-at-risk" (a measure of the likelihood of funding status volatility exceeding a certain figure), the authors recommend "selecting a glide path" -- elsewhere referred to by various titles, including dynamic de-risking and liability-responsive asset allocation -- "for surplus value-at-risk as the pension plan moves from deficit, to fully funded, to surplus" that changes asset allocation on a schedule.
To do this, IBM's Kanner says, the first move is to put on longer duration fixed income "using corporate and/or long government bonds. Corporate bonds are likely a better match against a fund's accounting liability." (Benchmarking being an essential issue here, for as funds move towards an LDI framework, a simple Barclays' Aggregate benchmark no longer suffices: Eventually, the benchmark must basically become the fund's mortality table and not the bond market). The goal at the start, Kanner says, is to stick to this more basic strategy before eventually entering into derivatives. Only later -- "when a fund is able to handle it," Kanner says -- should derivatives be brought into the equation.
Here's where it gets more complicated. "It's like peeling an onion," says Bob Collie, Chief Research Strategist at Seattle-based Russell Investments. "It starts with duration matching, but that isn't anywhere near the ending. After duration matching is implemented, managers need to find the most appropriate instrument to do the hedging. The relative pricing and effectiveness of the various tools used -- Treasurys, corporates, swaps, and other derivatives -- vary over time, so managers need to find the best combination to use at any specific moment."
Possibly even more important than the theory behind the LDI glide path -- for both the fund and the idea of LDI 2.0 -- is how to actually implement it within the realities of a corporate culture. "There is a lot of design discussion and agreement," says Northern Trust's Campbell. "Sometimes, funds need to start earlier in looking at their investment policy statement (IPS), and look to see whether there is, potentially, something in there that could tie their hands and inhibit LDI implementation." One example cited by Campbell is the fixed-income benchmarks. "If your investment policy statement specifies a fixed-income benchmark such as an aggregate bond index, does this allow you at any time to extend duration to 12 to 15 years? Or do you have to convene the Investment Board to begin discussing alternative fixed-income benchmarks before asset allocation can be changed?"
The next step, Campbell says, is cementing the glide-path mentality into the investment board's mind, as well as the IPS. If the theory of LDI is not institutionalized in this way, the idea goes, the door is left ajar for future board members and investment staff to wiggle out of the glide path and, let's say, ride an equity wave until the bubble bursts. "It's about discussing LDI at board meetings, and saying 'When this happens in the markets, that will happen to our fund.' It's about writing into the IPS how much and when to shift from risk-seeking assets into fixed income, depending on funding ratios. We've persuaded some boards to insert specific language into their IPS saying 'here is the allocation now; here are projected allocations in the future.' That's new." While many new ideas are often resisted, this one largely has not been. "Putting together a glide-path strategy and educating stakeholders about it, it's going well," says Russell's Collie. "It is easy to educate people about it. You don't need to be an investment specialist to understand the value of putting a glide-path in place. Once it's in place, it's hard to change." What Collie, Campbell, and others are saying, in effect, turns the often-pejorative talk of institutional momentum on its head: Instead of amounting to a bad thing, an institution's intrinsic inability to change quickly will go far toward ensuring that the glide-path remains in place, even if the temptation of a roaring equity market appears once again.
One concern voiced by industry commentators is that the increased complexity seen with the addition of derivatives to the LDI equation will frighten away some who may have been harmed in 2008 by complex instruments that were, in hindsight, misunderstood. With internal corporate pension teams stretched already, the thinking goes, how can they handle the increased scrutiny required of them when entering the world of LDI 2.0? The solution, Russell's Collie says, lies in delegation. "Managers are closest to markets," he says, referring to the large fixed-income houses that often execute LDI strategies for corporate funds. "The key is to actually put the onus on them to judge how to best use these complex instruments -- that's a trend that is in its early stages. Shift the complexity onto the manager."
When the aforementioned iPhone and Windows operating systems mutated from versions one to two, the changes involved were ones of degree: a changed user interface here, a rounded edge in lieu of a straight one there. Not so for liability-driven investing. Duration matching is one thing. Complex derivatives, glide-paths, and altered investment policy statements are another. To successfully navigate this change at pension funds -- and, by extension, their corporate sponsors -- is either to thrive in a volatile economy (think: LDI-focused pensions that have yet to wreak havoc at their respective organizations) or stumble (think: companies whose profits have been decimated by pension accounting issues). The dividing line between these two groups is this: overcoming the quandary of when you most want to implement it, you can't, and when you can, you don't want to. --Kip McDaniel