LDI Fundamentals: Where to Begin?

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1 LDI Fundamentals: Where to Begin? xczcxzcx A framework for designing a pension investment strategy Pension plan sponsors have increasingly been considering liability-driven investment (LDI) strategies as an approach to manage pension risk. An organization that adopts an LDI strategy for its defined benefit pension plan reduces the level of financial uncertainty within the plan, freeing the organization to focus on its core expertise areas. Reams Asset Management helps pension plan sponsors design, execute and monitor investment strategies. We offer these services to support our clients existing relationships with investment consulting and actuarial firms. This article, part of our LDI Fundamentals series, describes a framework for the design of liability-driven investment strategies. LDI Design Framework Simply stated, our design process begins and ends with the client. Rather than offering textbook solutions, we prefer to walk with a plan sponsor through an exploratory, iterative discussion regarding strategic objectives, sources of pension risk, and potential options to address unwanted risks. Of course, no two LDI design discussions will ever be the same (because every plan sponsor has unique preferences, risk tolerances and circumstances); nevertheless, Exhibit A illustrates a generalized framework, summarizing common phases of an LDI design discussion. Exhibit A: LDI design framework 1. Clarify Objectives A plan sponsor considering an LDI strategy should first clarify and articulate the ultimate objective for the strategy. For instance, is predictability of future contribution requirements important, or is it more important to take additional financial risk to try to reduce future contributions? How much volatility can be tolerated on 227 Washington Street, P.O. Box 727 Columbus, IN

2 the sponsor s balance sheet or income statement? Is the sponsor open to maintaining the plan indefinitely or must the goals be met within a specific timeframe? A plan s current investment approach may prove to be inconsistent with the sponsor s ultimate objectives. The current strategy may have been formulated from an asset-only perspective at some point in the past without the true ultimate objectives in mind, or perhaps the plan sponsor s objectives have evolved over time. Regardless, the process of identifying ultimate objectives often requires frank discussions within the sponsor organization and a willingness to embrace a change in mindset. Whereas in the past, pursuit of high positive asset returns may have been the goal (and negative returns always seen as failures), of primary importance now is the impact of investment returns (positive or negative) on the sponsor s ability to achieve its strategic objectives. For a discussion of three guiding principles that may help a sponsor clarify its strategic pension objectives, please see another article in our LDI Fundamentals series: What s the Big Idea? Three guiding principles for liability-driven investment strategies. 2. Identify and Prioritize Risks Having clarified its primary strategic goals with respect to its pension plan, a sponsor must next seek to understand the level of risk that exists within the plan. Exhibit B lists key types of financial risk that plan sponsors must consider. Each of these risks could adversely impact corporate financial statements or cash flow (either by affecting plan assets, liabilities, or both). Risk Interest rate, Yield curve Credit basis Equity exposure, Alpha exposure Demographic / actuarial Description Unexpected changes in the level or shape of the Treasury yield curve Unexpected changes in market yield spreads for non-treasury fixed income securities (corporate bonds, securitized loans, etc.) Unexpected changes in value of the plan s equity investments or actively managed investments Unexpected changes in demographics of pension plan participants (or actuarial assumptions regarding plan participants) Potential Pension Impact Assets and liabilities Assets and liabilities Assets Liabilities Exhibit B: Key financial risks in pension plans Although definitions like these can be found in numerous sources including academic textbooks, the risk prioritization process itself is anything but textbook. One plan sponsor s tolerance for credit basis risk, for instance, may be diametrically different from a second plan sponsor s tolerance. 2

3 For each type of pension risk, a sponsor should carefully consider the following issues: To what extent is the sponsor exposed to this risk? Does the sponsor expect to be adequately compensated for maintaining this risk exposure? Can this risk be mitigated or hedged? Rarely can a single solution immediately eliminate all sources of pension risk. Ordinarily a plan sponsor must prioritize which risks to minimize and which risks to assume. The prioritization exercise is a critical element in the LDI design process, because it helps both the sponsor and its advisors understand which risk factors are most important to address. 3. Analyze and Model Quantitative analysis fuels the LDI design process by helping a plan sponsor evaluate upside and downside risks for potential strategies. We use quantitative risk analysis both to assist the sponsor in prioritizing risks and to identify strategies that embody that sponsor s priorities. Our toolkit contains deterministic (predetermined scenario), probabilistic (mean/variance) and stochastic (random sampling) models which together offer a plan sponsor a range of perspectives from which to make informed decisions. Exhibit C shows a sample Pension Risk Summary report. We use this proprietary report to communicate with a sponsor regarding its level of pension risk. For a discussion of the key elements shown in the Pension Risk Summary report, please see another article in our LDI Fundamentals series: Is Our Strategy Working? A survey of pension risk management metrics. Exhibit C: Pension Risk Summary report (sample for illustrative purposes only) 3

4 4. Formulate Strategic Asset Allocation Establishing an optimal strategic asset allocation is a key goal of the entire LDI design process. Typically, several cycles through the preliminary phases of this process will be needed before a sponsor and its advisors mutually discover the right strategic asset allocation. The right allocation will have both a sufficient likelihood of meeting plan objectives and a sufficiently controlled downside risk. The right allocation for a sponsor typically also strikes an intentional balance between hedging assets (e.g., investments designed to reduce pension risk) and return-seeking assets (e.g., investments designed to take calculated risks in hopes of improving returns). Exhibit D illustrates the projected asset and liability cash flows for a strategic asset allocation considered by one of our clients. We tailored this strategy to the plan s specific risk tolerances by using a weighted average of six commercial fixed income benchmarks overlaid with Treasury futures. Exhibit D: Cash flow modeling (sample for illustrative purposes only) 5. Set Triggers for Modifying Existing Portfolio Allocation In the shadow of steep declines in pension funding status since 2000, many pension plan sponsors currently express a desire to mitigate pension risk. However, for a variety of credible reasons, some plan sponsors feel reluctant to immediately implement a lower-risk strategy. Some popular sentiments are: 4

5 Fixed income yields are near historic lows (translating to prices perceived to be high), making some plan sponsors reluctant to increase fixed income allocations. An immediate and significant shift in strategic asset allocation may impose substantial transaction costs. Plan sponsors with large funding deficits are reluctant to give up the perceived potential upside of investing in stocks. (For plan sponsors with fully funded plans, there is often little or no upside to retaining substantial equity investments; here the case for immediate de-risking becomes more compelling.) There are potential counters to each of the arguments listed above; nevertheless, it may be reasonable to delay immediate implementation of an LDI strategy. In this circumstance, we recommend setting the ultimate goal now (i.e., What is our ultimate target? ), then establishing triggers that will result in incremental modifications to the current allocation (i.e., How do we get from here to there? ). This approach (often called a glide path or dynamic de-risking ) is common practice, with triggers often established by plan sponsors based on funding status, interest rate levels, market index values or fixed calendar dates. Summary Pension plan sponsors face a myriad of financial risks and a seemingly endless array of potential strategies for addressing those risks. Although every plan sponsor s approach to implementing an LDI will necessarily be unique, a structured design framework facilitates selection of a pension investment strategy that aligns with a sponsor s objectives. For More Information We welcome the opportunity to speak with you further about how Reams Asset Management may help pension plan sponsors achieve their strategic pension objectives. For more information please visit our website ( or contact us directly: Todd Thompson, CFA Portfolio Manager ; tthompson@reamsasset.com Trey Harrison, CFA, ASA Fixed Income Analyst/Actuary ; tharrison@reamsasset.com Brett Dutton, CFA, FSA, EA Fixed Income Analyst/Actuary ; bdutton@reamsasset.com This report is provided for informational purposes only and contains no investment advice or recommendations to buy or sell any specific securities. The projections or other information included in the report are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Statements in this report do not constitute an actuarial opinion on behalf of the authors or Reams Asset Management. Statements in this report are based on the opinions of the author and the information available at the time this letter was written. All opinions are subject to change without notice. All investments involve risk, including the possible loss of principal. Reams Asset Management is a division of Scout Investments, Inc., a registered investment advisor that offers investment management services for both managed accounts and mutual funds. Scout Investments is a wholly owned subsidiary of UMB Financial Corporation. Copyright UMB Financial Corporation. All Rights Reserved. 5