Liability Driven Investing

Transcription

1 Liability Driven Investing Liability Driven Investing (LDI) is an investment framework that focuses on managing pension assets in relation to pension liabilities. LDI is not new, as insurance companies have used similar strategies for years under the name of Asset-Liability Management (ALM). What is new is that defined benefit plan sponsors now have significantly increased motivation to manage pension assets by taking into account pension liabilities, with a focus on managing volatility of the overall pension funding status. Why LDI Now? Recent changes in pension funding laws and accounting standards, coupled with unprecedented volatility of the securities markets and subsequent rebound of interest rates and pension funding levels, have created significant incentives for pension plan sponsors to actively manage pension plan risks and, as a result, adopt LDI strategies: Financial Reporting Requirements. Financial Accounting Standards Board statement ASC 715 (26) requires companies to report funding status of defined benefit plans on their balance sheet, leading to high balance sheet volatility. The second phase of the accounting reform is in progress, and the proposed changes may significantly increase volatility of the pension expense reported on the income statement. Pension Funding Requirements. The Pension Protection Act of 26 (PPA) drastically changed pension funding rules by significantly reducing smoothing of pension assets and liabilities, introducing several yield curve options to determine pension liabilities, increasing Pension Benefit Guarantee Corporation premiums, and requiring full funding of pension plans over an accelerated seven-year period. This was somewhat offset by subsequent pension legislation, such as The Moving Ahead for Progress in the 21st Century Act (212) or MAP-21, that allowed additional smoothing of pension liability interest rates. Increased Capital Markets Volatility. Volatility of capital markets was unprecedented in recent years, leading to significant volatility of pension assets and liabilities, and resulting in volatility of pension funding status, cash contributions, pension expense, and balance sheet impacts. Increased Pension Plan Operations Complexity. Pension plan operations complexity increased substantially due to the new requirements under PPA with respect to the time sensitive certifications of pension funding ratios (Adjusted Funding Target Attainment Percentage or AFTAP) and the introduction of AFTAP-based pension plan restrictions, (eg. lump sum and accrual restrictions). Therefore, stable pension funding ratios became very important for the operations of the pension plans under PPA. Improved Pension Funding Levels. Funding levels of pension plans rebounded significantly after the credit crisis of 28, while declining slightly during 214. Generally improved funding levels make LDI strategies more appealing today than in the past as companies see an opportunity to lock-in recent gains. Interest Rates Rebound. Even though interest rates remain at depressed levels, they increased significantly during 213, while declining somewhat in 214, making LDI strategies more attractive now than in the past.

2 A Comprehensive Solution Designed to Manage Pension Risks Given the current market conditions and funding levels of the pension plans, our LDI approach is based on the following key steps: Initial Analysis ALM Study Dynamic Asset Allocation Liability Hedging Strategies Liability-Based Benchmarks Monitoring / Rebalancing Initial Analysis LDI strategies start with a comprehensive analysis of a pension plan s specific benefit provisions and key economic and demographic assumptions, plan s liability cash flows and other demographics, plan s contribution policy, funding policy and investment policy statement, and many other key elements of pension plan operations. Asset-Liability Management Studies The pension plan s risk profile is analyzed based on Asset-Liability Management (ALM) studies, carried out at the inception of the LDI strategy and typically repeated every 2-3 years. ALM studies are based on a probabilistic analysis, such as Monte Carlo simulations, and are well suited for modeling pension assets and liabilities, which are highly volatile and uncertain. Dynamic Asset Allocation The key feature of the LDI framework is dynamic asset allocation or glidepath. LDI strategy starts with only a small (if any) pre-determined percentage of assets allocated to the liability hedging assets. Over time, if and when funding status improves, periodic rebalancing leads to the increased allocation to the liability hedging assets, where such periodic rebalancing is done according to the glidepath schedule created and adopted at the inception of LDI strategy. Liability Hedging Strategies Once the dynamic asset allocation is established, a number of strategies are considered in order to create a so-called liability hedging asset class, which would have very high correlation with pension liability and therefore be used to effectively hedge pension liability. Liability-Based Benchmarks The main objective of LDI strategies is to optimize volatility of the pension plan s funding status. As a result, the most appropriate benchmark for LDI strategies is the return on a pension plan s liabilities and plan-specific liability based benchmarks are created and customized for each plan in order to assess the performance of LDI strategies. Monitoring and Rebalancing Monitoring and rebalancing are essential parts of the LDI framework with market values of pension assets and liabilities determined on a regular basis. Once the thresholds are reached as specified by the dynamic asset allocation decision rules established at the inception of the strategy, asset rebalancing is initiated and any funding status gains earned are locked in. 2 Liability Driven Investing

3 Asset-Liability Management Study The Asset-Liability Management (ALM) study is a useful tool for incorporating pension plan risks, as measured by funding status and contribution volatility over time, into the plan sponsor s decision making process with respect to plan design, contribution strategy, investment policy, strategic asset allocation, and enterprise risk management. ALM studies typically include 1-year (or longer) projections of pension funding status, expenses, balance sheet impacts, cash contributions, and the like, on a probabilistic or Monte Carlo simulation basis. Charts 1 and 2 show projected funding status and cash contribution requirements represented by a spectrum or range of outcomes for a current asset allocation as compared to the dynamic asset allocation framework. Chart 1: Funding Ratio Chart 2: Cash Contribution 25 Left Bar: Current Asset Allocation Right Bar: Dynamic Asset Allocation PERCENTAGE 1 $ MILLIONS Percentile Percentile 75-5 Percentile 5 Percentile 5-25 Percentile 25-5 Percentile 1 Percentile LIABILITY HEDGING ALLOCATION, % 1 Chart 3: Liability Hedging Allocation DISCOUNT RATE, % FUNDING RATIO, % Dynamic Asset Allocation Since the main goal of the LDI framework is to control pension plan risks, defined as volatility of pension funding status and cash contributions, and subsequently lock in the gains once they are realized over time, an LDI strategy is designed as dynamic in nature. Asset allocation rules for rebalancing from the return seeking portfolio to liability hedging assets are specified in advance, i.e. at the inception of the strategy, and the portfolio is rebalanced when pension funding status improves and/or other conditions are met. Chart 3 provides an illustration of the decision rules for the LDI dynamic asset allocation strategy based on changes in the pension plan s funding status and levels of discount rates. For each level of discount rate and funding ratio, a bar represents an allocation to the liability hedging asset while the rest is invested in the return seeking portfolio. 3 Liability Driven Investing

4 Liability Hedging Strategies $ MILLION Chart 4: Liability Cash Flows Once the glidepath is created, the next step is to construct a portfolio of fixed income securities that is highly correlated with pension liability. Such a portfolio is constructed based on pension plan specific liability cash flows as illustrated in Chart 4 and once the cash flows change, which typically happens every year after the completion of the actuarial valuation, the liability hedging asset is updated and the portfolio is rebalanced Strategies that can be used for liability hedging are: YEARS Cash Flow Matching or Full Replication: replication of pension liability cash flows with coupons and principal payments from a portfolio of fixed income securities. This will result in the lowest tracking error of assets and liability. Duration Matching: a fixed income portfolio that only matches total dollar duration of pension plan liability, resulting in greater tracking error of assets and liability, but providing higher yield than full replication. Key Rate Duration Matching: a fixed income portfolio that matches several key rate durations of pension plan liability, resulting in smaller tracking error of assets and liability than duration matching. Factor Duration Matching: utilizing advanced strategies, such as Principal Component Analysis, in order to create a portfolio of fixed income securities that matches sensitivity of pension liability to changes in yield curve level, slope and curvature. Horizon Matching: a full cash flow matching of the near-term liability cash flows to provide for benefit payments, and applying matching strategies (based on duration, key rate duration or factor duration) for cash flows with longer maturities. Additional More Advanced and Customized Strategies Liability-Based Benchmark Construction Since the objective of the LDI strategy is to manage pension plan assets in relation to liabilities, the LDI benchmark should be directly related to the pension plan s liabilities and asset-only benchmarks should only be used as supplemental benchmarks if plan sponsors so desire. U.S. Generally Accepted Accounting Principles define pension obligation as the current market value of a hypothetical portfolio of high-quality zero coupon bonds whose coupon and principal amounts at each maturity are the same as the expected future pension benefit payments. PPA defines pension obligation (the Funding Target) as expected future pension benefit payments discounted with full yield curve or three-segment rate yield curve published by the Internal Revenue Service and based on investment grade corporate bonds in the top three quality levels. 4 Liability Driven Investing

5 Given these definitions, the ideal LDI benchmark should be a hypothetic portfolio of investment grade corporate bonds selected in such a way that coupon and principal cash flows from this bond portfolio match the projected benefit cash flows from the pension plan. Other liability-based benchmark options are also available. Monitoring and Rebalancing Monitoring and rebalancing are integral parts of LDI strategy implementation. Every month, or more frequently if market conditions warrant, the market values of pension liabilities and funding ratios are determined, and the rebalancing is done as specified by glidepath. This information is delivered to our clients on a quarterly basis as part of our Funding Status Update reports (Chart 5), which provide the following key information, otherwise not available to the pension plan sponsors: Funding status information on a quarterly basis (otherwise available only annually after completion of actuarial valuations) Documentation of movement along the glidepath and any required rebalancing Liability hedging asset performance as benchmarked to pension obligation returns Overall LDI strategy performance as indicated by the stability and/or improvements of funding ratios Chart 5: Funding Status Update Report 211 Fiscal 212 Fiscal 213 Fiscal Year Year-End Year-End Q1 Q2 Q3 Q4 Measurement Date 12/31/211 12/31/212 3/31/213 6/3/213 9/3/213 12/31/213 Discount Rate 3.75% 4.15% 3.93% 3.82% 3.84% 3.87% Assets 42,43,245 42,98,24 44,269,647 45,597,737 46,965,669 48,374,639 Liability 48,113,857 49,936,22 5,399,623 5,66,613 5,26,585 49,756,8 Funding Status (5,71,612) (6,955,782) (6,129,976) (5,62,877) (3,24,917) (1,382,161) Funding Ratio 88.1% 86.1% 87.8% 9.% 93.5% 97.2% Oleg Sydyak CFA, FSA, EA Director, Head of Asset and Liability Strategy oleg.sydyak@pnc.com Liability Driven Investing

6 Liability Driven Investing The PNC Financial Services Group, Inc. ( PNC ) uses the marketing name PNC Institutional Asset Management SM for the various discretionary and non-discretionary institutional investment activities conducted by PNC Bank, National Association ( PNC Bank ), which is a Member FDIC, and investment management activities conducted by PNC Capital Advisors, LLC, a registered investment adviser ( PNC Capital Advisors ). PNC Bank uses the marketing names PNC Retirement Solutions SM and Vested Interest to provide non-discretionary defined contribution plan services and PNC Institutional Advisory Solutions SM to provide discretionary investment management, trustee, and other related services. Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. Securities products, brokerage services, and managed account advisory services are offered by PNC Investments LLC, a registered broker-dealer and a registered investment adviser and member of FINRA and SIPC. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC does not provide investment advice to PNC Retirement Solutions and Vested Interest plan sponsors or participants. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors. Vested Interest is a registered trademark and PNC Institutional Asset Management, PNC Retirement Solutions, and PNC Institutional Advisory Solutions are service marks of The PNC Financial Services Group, Inc. INVESTMENTS: NOT FDIC INSURED - NO BANK OR FEDERAL GOVERNMENT GUARANTEE - MAY LOSE VALUE 214 The PNC Financial Services Group, Inc. All rights reserved.