A Perfect Fit
As pension funds try to cope with the ongoing financial crunch, more are turning to liability-driven investing strategies for their future.
The dot-com bust in 2000, September 11, 2001, and the credit crisis of 2008 in particular devastated pension fund values, leaving many public and private pension plans seriously underfunded. That is the landscape, but some pension funds are now trying on a new investment style.
Traditionally, pension funds invested 60 percent of their assets in equities and 40 percent in fixed income, and measured their performance using benchmarks such as the S&P 500 for stocks and Barclays Capital Aggregate Bond Index. The problem with this methodology is that it fails to measure the actual funding of liabilities. Even a fund that regularly outperformed these indices could be underfunded. So more pension funds and companies are adopting another approach called liability- driven investment (LDI) to help address the long-term viability of their pension plans. An LDI strategy is not simply diversifying from equities into fixed income, it is a risk framework that attempts to align the exposures of the assets to those of the liabilities. Gordon Latter, managing director of risk based solutions at RBC Global Asset Management, says that LDI is not a straightforward product sell. "LDI is a strategic framework, it doesn't fit neatly into a box," Latter explains.
The LDI Solution
Part of the problem with more traditional pension fund investing is the bonds that make up the benchmark are short in duration, while the pension plan has liabilities that stretch well into the future. A pension fund needs to match its liabilities with bonds that have durations of 15 years or more.
"To neutralize risk they have to invest in bonds that match the duration of their liability," says Tom Lee, senior portfolio manager and principal at investment management firm The Clifton Group. "They have not traditionally done this. They have invested in equities or bonds that did not match."
Enter LDI strategies, which aim to produce enough assets to meet all current and forward liabilities. Many major corporations, such as Boeing, Ford, J.C. Penney and Alcatel-Lucent, have embraced LDI to help manage so-called defined benefit pension programs. And the strategy is paying off, according to consultancy Watson Wyatt, which reported that pension funds employing LDI strategies significantly outperformed funds with traditional asset allocations in 2008. The firm estimated that portfolios using LDI strategies returned negative single digits to break-even last year, while traditional strategies lost 20 to 30 percent or more.
Pension fund investors understand they are exposed to interest rate risk, but often are not convinced that adding interest rate exposure will add value. An alternative gaining acceptance is the use of a derivatives overlay that offers synthetic gains on interest rate exposure, while leaving more cash available for higher return strategies. "An overlay strategy – using interest rate futures or swaps – provides you with an alternative to the cash markets," Latter says. "With overlays you can take advantage of yield pickup and leverage and by tying up less capital you can deploy your capital into existing strategies."
"Before this they looked at absolute returns in terms of percentages and benchmarks," Lee says. "Now they are saying, 'We get it, we have to manage surplus risk.' They need to invest assets in appreciation of the liability. This generally leads to less equities and more interest rate exposure."
Defining the future
Defined benefit pension funds have attracted a lot of attention over the past year as the credit crisis sent many of their assets versus liabilities far underwater. If a company�s market capitalization is $2 billion and its pension fund is $2 billion, it could mean financial pain if those assets and liabilities are not managed correctly, Lee says.
In addition, pension liabilities could be the next big thing in terms of due diligence during the merger and acquisition process. There is growing evidence that research analysts are now paying more attention to a company's pension liabilities as part of their buy or sell recommendations.
New regulations proposed last year by the Financial Accounting Standards Board will effectively mandate mark-to-market accounting of assets and liabilities. They will also prevent firms from 'smoothing' the interest rate curve by forcing firms to discount the liabilities to their present value.
"Historically, accounting standards allowed for smoothing so it was never apparent if there was a real-time deficit," Lee says. "Now we are moving to more real-time mark to market of assets and liabilities that is in line with global accounting standards. There is a need to make pension risk more transparent." Lee believes there is a wave of acceptance" toward using LDI to manage risk more actively.
"Overlay strategies for the fixed income element give firms the flexibility to employ longer duration opportunities," Lee says. "This means swaps and futures could have applications in many funds, as these instruments help to manage surplus volatility."
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