Srini Venkateswaran Edgar Baek Deneb Shah. Strategic Opportunities for Asset Managers in U.S. Liability- Driven Investing (LDI)

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1 Leading Research Tracie Redd Srini Venkateswaran Edgar Baek Deneb Shah Strategic Opportunities for Asset Managers in U.S. Liability- Driven Investing (LDI)

2 Executive Summary sees significant opportunities for U.S. asset managers seeking to enter the liability-driven investing (LDI) space Recent economic events are reshaping the sentiments of senior finance executives, increasing sensitivity to managing pension plan risks and contribution volatility versus focusing on investment returns U.S. pension plans continue to experience significant asset-to-liability mismatch, and as discount rates continue to decline, future value of pension liabilities will correspondingly rise Asset allocations continue to favor fixed income and alternative investments; equity concentration decreased about 25% from 2004 to 2009 The U.S. LDI market should evolve much as the U.K. and Dutch markets have and experience a similar growth rate LDI adoption in the U.S. is steadily growing and becoming more compelling for frozen and closed plans with funding ratios greater than 85% across all size segments There are a number of ways to play, and they require careful analysis to optimize market entry Asset managers will need to reconfigure existing functions and build new capabilities specifically to meet the needs of LDI mandates Insurance asset managers already possess core capabilities that help address the major risk concerns facing U.S. plan sponsors 1

3 Several important trends are converging to create a tipping point for rapid growth of the U.S. LDI market Industry Trends De-Risking and Focus on Asset Liability Management Regulatory/ Accounting Changes Description Heightened focus on better managing assets in concert with liabilities in light of inherent volatility of equity markets and current low yield environment 2006 Pension Protection Act (PPA) established funding target attainment percentages (FTAPs) for corporate DB plans (100%) and established guidelines for valuation of plan assets 2006 FASB accounting rules (FAS 158) required recognition of the plan s assets and liabilities on corporate balance sheet Impact on LDI Corporate defined benefit (DB) plans are shifting asset allocations for fixed income strategies and alternative investments by phasing in more conservative LDI strategies More than half of BNY Mellon s clients have moved at least a portion of their assets to LDI strategies J.C. Penney is rebalancing the asset mix in its US$4.3 billion pension plan to be 75% invested in fixed income in a few years Lower tolerance for volatility, given its potentially negative impact on balance sheets, has triggered movement to strategies such as LDI to immunize corporate parents while securing more predictable investment behavior and more prudent investment options Improved Funding Levels Source: FT.com; FAS 158; 2006 PPA; Russell Investments Although pension plans are still short of full funding, the average funding gap has been reduced to 1 or $255 billion, down from a record $460 billion in 2008 Improved funding levels enable plans to consider alternatives to equity strategies and reduce opportunity cost to transition to LDI framework It s now easier to implement an LDI strategy as insurance against future market volatility and swings in interest, credit, and inflation rates Improved funding level increases the ability to close and/or terminate plan and shift to full LDI strategy 2

4 Funded Ratios Rate of Return U.S. pension plans continue to experience a significant asset-toliability mismatch Investment Return on Plan Assets % 4% % -6% % -9% % 19% Source: Milliman 2011 Pension Funding Study 12% 11% % 10% Expected Return Actual Return % 2008 Projected Benefit Obligation Funded Ratios 14% % % Observations U.S. defined benefit plans experienced record investment gains over the last two years, recouping the losses incurred in 2008, but the market value of DB plan assets is still 9% below 2007 levels On average, U.S. defined benefit plans are still underfunded, with firms showing funding ratios of 83.9% in 2010, an improvement of 2.2% from the prior year As discount rates (tied to Aa corporate bond yields) continue to decline, the future value of pension liabilities will correspondingly rise In 2010, large corporations (e.g., Honeywell, Verizon, and AT&T) decided to recognize (in varying degrees) their pension liabilities on their balance sheets 3

5 The movement in asset allocation strategies away from equities is already evident in the U.S. market and impacts all plan sizes S&P 500 (U.S. Plans Only) 70% 60% 50% % 48 Observations Corporate DB plans decreased their allocations to equity by ~25% between 2004 and % 30% They increased their allocations to debt securities by 25% from 2004 to 2009 This shift toward more conservative assets is intended to: 20% 10% 0% Mitigate variability in investment return and thus volatility in funded status and contributions Better align plan assets with liabilities Protect existing assets from market risk Equity Debt Other Real Estate Source: Goldman Sachs Global Markets Institute; Capital IQ; company reports 4

6 Adoption of LDI strategies will continue to rise as plan sponsors seek ways to manage risk while funding future pension liabilities Major Concerns of Senior Finance Executives Related to Their Company s DB Plan LDI Adoption (% of respondents in a survey) Cash flow impact Income statement impact % 54% 50% Balance sheet impact Regulatory requirements % Credit rating impact Recruitment/retention impact 25 Reduce 16Risk Increase Return = Area of focus 20% Public image impact 16 Other Overwhelming majority (7) of finance executives indicated a strong interest in reducing overall risk versus increasing investment returns There is strong concern over controlling contribution volatility and its impact on financial statement reporting Pursuing pension risk management practices, like liability-driven investing, will likely become more popular with corporate plan sponsors Source: SEI; Vanguard; CFO Research Services and Towers Perrin: A Qualified Commitment to DB Plans : analysis Adoption of LDI strategies by pension plans increased by more than 35% between 2007 and 2010 LDI strategy implementation is likely to increase in the future 77% of large DB plans ($1 billion or more) plan to increase their allocations to LDI strategies 37% of midsized plans ($100 million to $1 billion) expect to increase their LDI allocations 2 of small plans ($20 million to $100 million) expect to increase their LDI allocations 5

7 In a bottom-up market view, we estimate that more than $610 billion in assets under management globally is in LDI strategies Ignis Asset Management $21 (3%) AXA Investment Managers $26 (4%) Goldman Sachs $18 (3%) Other $47 () BlackRock $150 (25%) Global LDI AUM Estimate, 2010 ($B) LDI assets under management (AUM) generally are not reported separately but rather as embedded components of fixed income AUM Asset managers experience, on average, 25% growth rates with LDI NISA $30 (5%) AUM is concentrated in the top three or four players, which hold 62% to 71% of market share LGIM $62 (10%) PIMCO $126 (21%) BNY Mellon (Insight) $130 (21%) Fees depend on strategy complexity but range from 10 to 15 basis points (bps) on the low end to a high of 50 bps for complex structures, with an average of 20 to 30 bps The largest cost is generally the opportunity cost of switching from higher- to lowerreturn assets Source: analysis 6

8 The U.S. LDI market (about 35% to 45% of the global LDI market) is dominated by three players, but new players emerge J.P. Morgan Northern Trust $5 (2%) Pyramis $5 (2%) $9 (4%) Cutwater $11 (5%) LGIM $15 (6%) Loomis Sayles $8 (3%) BlackRock $50 (21%) Source: analysis U.S. LDI AUM Estimate ($B) (Top 12 Players, 2010) Goldman Sachs $4 (2%) Jennison $2 (1%) BNY Mellon Asset Management (Insight) $1 (1%) PIMCO $72 (31%) Prudential $52 (22%) The U.S. market is heavily concentrated, with PIMCO, Prudential, and BlackRock holding the bulk of the market share LDI services are offered by some major insurance companies (Prudential, ING, MassMutual/Babson Capital) Most LDI mandates are no more than two years old LGIM entered in 2010 and has already captured a sizable market share Pacific Life, an incumbent player, offers Insured LDI (a guarantee to match an LDI benchmark, thereby increasing funding status stability) The majority of LDI mandates are for longduration strategies, some with derivatives overlays Other LDI asset managers include Barclays Capital, BNP Paribas, GSAM, Morgan Stanley, SEI, State Street, UBS, Vanguard, and Western Asset 7

9 The U.S. LDI market should evolve much as the U.K. and Dutch markets have and experience similar growth rates U.K. LDI Market Evolution Regulatory/ Accounting FRS 17 pension deficits on balance sheet; increase in balance sheet volatility Pensions Act requires 100% funding by 2014 % Plans Using LDI LDI AUM ( B) LDI Products 0% 19% 42% 50% 67% 0% Interest rate swaps Long-duration bonds Inflation swaps Equity collars Synthetic debt & equity Swaptions Longevity swaps Increasing complexity Average Fees bps basic bps basic bps dynamic & complex Frozen Pension Assets/Terminations Few frozen 73% pension assets frozen The Dutch market followed a similar pattern with the introduction of new accounting standards (IAS 19) leading to balance sheet impact and funding requirements above 100%. The Dutch market witnessed a shift from equities to fixed income and derivative LDI strategies with more than 94% of plans implementing an LDI framework by 2009 Source: client experience 8

10 LDI adoption becomes compelling for frozen and closed plans with funding ratios greater than 85% across all size segments Defined Benefit Plan s Current Funding Status, 2010 (Total U.S. DB AUM = $6.3T) Maturity of Defined Benefit Plan, % 13% 100% or more 19% 23% 90%-99% 21% Frozen 2 32% Active 41% 32% 4 80%-89% 23% 3 12% 17% 10% 6% 70%-$79% Less than 70% Closed $20M-$100M $100M-$1B $1B+ = Area of focus Source: Vanguard: Survey of Defined Benefit Plan Sponsors, 2010 ; SEI: 4 th Annual LDI Poll ; analysis 9

11 To understand potential ways to play and market entry options, asset managers need to consider the full DB/LDI ecosystem Defined Benefit/LDI Ecosystem Pension Plans Corporate plans Public plans Intermediaries Investment consultants Outsourced CIO LDI* Solutions Pure immunization Duration extension of fixed income assets Portable alpha as a replacement for equity risk premiums Long-duration bonds Corporate bonds Treasury STRIPS TIPS High-yield bonds Investments Zero coupon bonds Interest-rate swaps Inflationlinked swaps Futures overlays Credit default swaps * Arranged by increasing complexity of implementation; only common solutions depicted. Source: ICI; Casey Quirk; Callan Associates; NEPC; analysis 10

12 A number of ways to play exist and require careful analysis to optimize market entry Ways to Play in the LDI Market ILLUSTRATIVE Product Niche Player Scale Player Affiliates Investment Boutique Investment competence/ performance Established track record with seasoned investment team Global footprint of investment professionals having dedicated LDI teams with proven investment approach Strong investment capabilities coupled with insurance experience Small investment boutique started by veteran investment managers with long experience at larger asset managers Breadth of investment capabilities Alternatives competence and access LDI consulting, customized LDI solutions, and asset management capabilities Shallow access to alternative investments Custom LDI solutions and prepackaged asset management through target date funds Access to proprietary hedge funds and private equity funds Single, focused LDI product with insurance wrapper (guarantee) Shallow access to alternative investments Asset allocation and asset/liability analysis; sometimes has in-house asset management capabilities Shallow access to alternative investments Distribution strength and scale Some are backed by larger asset managers (e.g., Fidelity) Strong and long-standing relationships with the country s largest DB plans Relationship with investment consultants Focus on smaller endowments, public and corporate plans Sophisticated risk management N/A Regionally based risk management systems; technologies are being refreshed Strong hedging capabilities; strong balance sheet/risk transfer capabilities Less sophisticated risk systems; usually used under ASP model Competitor firms Pyramis Brandes Investment Partners Legal & General BlackRock State Street PIMCO Vanguard Invesco SEI Russell Northern Trust Pacific Life Makena Rocaton New Providence Morgan Creek Source: analysis 11

13 An intimate understanding of plan sponsors special needs, along with a consultative sales approach, is essential in LDI Plan Size $10B-$50B $1B-$10B $500M-$1B $100M-$500M Less than $100M Obstacles to Launching an LDI Program 13% 15% 15% 25% 23% 27% 33% 33% 33% 40% % 60% N = 51 Observations LDI as an investment strategy is not well understood, even in large plan sponsors, due in part to its complexity Lack of education has been the biggest hurdle across various sizes of pension plans Consultative selling should focus on educating plan sponsors on the plan conditions that are conducive to LDI More Education and Technical Understanding Interest Rate Environment Market Volatility Decline in Funded Status Note: Multiple responses were allowed. Decline in funded status caused by market impact to the plan s assets and liabilities. Sample sizes by segment are not statistically valid, but are directionally correct. Source: Cutwater Asset Management; Pyramis Global Advisors; Putnam Investments/Pensions & Investments 12

14 Managers will need to reconfigure existing functions and build new capabilities specific to meeting the needs of LDI mandates ILLUSTRATIVE Asset Manager Capability Model LDI Capabilities Client/Account Services Portfolio Management Services Order Management and Execution Services Transaction Support Services Asset Servicing Services Data Services Vendor Management Services LDI Portfolio Strategy Services Product Innovation Services Risk Control Services Legal Services LDI Analysis Portfolio assessment/ modeling Asset inflows Liability outflows Cash flow mismatch analysis Company financials Portfolio Objectives Portfolio objectives Meet/exceed liabilities De-leveraging Yield enhancement Liquidity management Strategy Development Current market opportunities Cash flow models Simulation Scenarios Stress testing Portfolio construction Risk tolerance Benchmarks Yield enhancement Portfolio Management Portfolio management Market surveillance Portfolio monitoring Rebalancing Risk management Derivatives overlay Source: analysis 13

15 Insurance asset managers already possess core capabilities that help address the major risk concerns facing U.S. plan sponsors Top Pension Risk Factors, Core Strengths Relevant to Market Entry Underfunding of Liabilities Asset & Liability Mismatch 2 26% 43% 47% 60% 66% Deep analytic/actuarial capabilities Understanding of liability cash flows and asset liability management modeling Asset Allocation 27% 45% 54% Ability to measure and manage risk Meeting Return Goals 23% 41% 49% Proven track record managing fixed income assets Ability to Measure Risk 35% 26% 29% Strong balance sheet/risk transfer capabilities = Area of focus Note: Multiple responses were allowed. Source: MetLife U.S. Pension Risk Behavior Index; analysis 14

16 Contact Information San Francisco Tracie Redd Partner New York Srini Venkateswaran Partner Los Angeles Edgar Baek Principal

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