LDI Fundamentals: Is Our Strategy Working?

LDI Fundamentals: Is Our Strategy Working? A survey of pension risk management metrics 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 basic tools and analyses that allow pension sponsors to monitor an LDI strategy s effectiveness. LDI Risk Management Metrics Our LDI risk management reports help clients assess the effectiveness of current investment strategies and identify residual sources of pension risk. We generate these reports using proprietary models tailored to meet the needs of our clients. In this article, we focus on two sample reports that have proven particularly useful: a pension risk summary report and a funding status return attribution report. (For a more general discussion of factors to consider when designing an LDI strategy, please see another article in our LDI Fundamentals series: Where to Begin? A framework for designing a pension investment strategy). Exhibit A: Pension Risk Summary report (sample for illustrative purposes only) 227 Washington Street, P.O. Box 727 Columbus, IN 47202 812.372.6606 www.reamsasset.com

1. Pension Risk Summary The sample pension risk summary report shown in Exhibit A includes several key LDI risk management metrics. In the following sections, we discuss portions of the report in detail. Funding Status The desire to protect a pension plan s funding status 1 lies at the core of LDI strategies. As such, frequent funding status estimates will help a sponsor understand the plan s financial health and make informed decisions to manage financial risks. To that end, we assist plan sponsors by providing periodic updates of a pension plan s estimated funding status. We can provide monthly, weekly, or even daily estimates of funding status to an interested plan sponsor. While these interim calculations are only estimates, we believe this information can help the sponsor keep a close watch on a pension plan s financial health. Exhibit A displays the current funding status estimate (92.0%) as well as the asset and liability values that comprise the estimate. Our funding status estimates are prepared by credentialed actuaries who take into account all available information, potentially including the following: Liability cash flows and/or recent pension actuarial reports (if supplied by plan sponsor) Actual asset value updates, contribution amounts, benefit payment amounts, and expenses paid (if supplied by plan sponsor) Actual month-over-month changes in liability discount rate curves Estimated changes in asset value (based on daily benchmark asset returns) Estimated changes in liability value (based on daily yield changes in the corporate bond universe) Duration Hedge Ratio A plan s duration hedge ratio 2 estimates the proportion of liability repricing (due to interest rate changes) that will be offset by changes in the market value of the plan s interest-sensitive investments. The duration hedge ratio shown in Exhibit A is 57.1%. This means that, for every $1 increase in pension liability due to interest rate changes, the plan s asset value is expected to increase by approximately 57 cents. 1 A plan s funding status is often expressed as a ratio of the plan s assets to liabilities. For purposes of this article, funding status calculations follow US GAAP accounting standards, which are a primary concern for many corporate pension plan sponsors. The concepts described in this paper also generally apply to funding status measurements for other purposes (e.g., US funding regulations or international financial reporting standards) but there are some differences in the details. 2 Duration is a measure of the sensitivity of the market value of a fixed-income investment (or present value of a pension liability) to changes in interest rates. Roughly speaking, a duration of 10.46 years (as shown for the plan liability in Exhibit A) implies an increase (decrease) of 10.46% for every 100 basis point (1.00%) parallel decrease (increase) in interest rates. 2

Several variations of the duration hedge ratio calculation exist within the investment management industry; the most basic of these assumes parallel interest rate changes across the term structure and credit quality spectrum (i.e., all interest rate changes are due to underlying changes in risk-free rates). A successfully-implemented LDI strategy should result in an increased duration hedge ratio (i.e., a greater portion of interest rate risk will be hedged). For instance, if the plan illustrated in Exhibit A were to immediately shift from 60% to 80% fixed income (with no changes to the duration of fixed income), the duration hedge ratio would increase from 57.1% to 76.1%. Conversely, if the plan were to immediately reduce its fixed income allocation from 60% to 40%, the duration hedge ratio would decrease from 57.1% to 38.0%. A plan sponsor typically examines duration hedge ratios when designing an investment strategy to ensure that the chosen strategy appropriately reflects the sponsor s objectives and risk tolerance. After implementation of a liability-driven investment strategy, the duration hedge ratio tends to drift over time due to changes in interest rates, investments, or funding status. By monitoring the duration hedge ratio on a regular basis, a plan sponsor can ensure that the implemented strategy remains aligned with strategic objectives. Dollar Value of a Basis Point (DV01) Closely related to the duration hedge ratio calculation is the dollar value of a basis point (DV01), which translates the plan s estimated interest rate sensitivity to dollar terms. Exhibit A shows that a one basis point (0.01%) parallel decrease in interest rates is estimated to result in a $339,000 increase in the sample plan s asset value and a $593,000 increase in the plan s liability value. In other words, the plan s net funding status will decrease by approximately $254,000. This result is consistent with the plan s 57% duration hedge ratio (since approximately 57% of the $593,000 liability increase is expected to be offset by a $339,000 increase in asset value). Contribution to Duration (CTD) The duration hedge ratio previously described is useful and popular because of its relative simplicity; however, it relies on an unrealistic assumption of parallel interest rate movements. In reality, daily changes in interest rates typically vary both across the term structure (i.e., long interest rates move differently than short rates) and across the credit quality spectrum (i.e., risk-free interest rates move differently than implied interest rates on riskier securities). To help sponsors understand their plan s exposure to non-parallel changes in interest rates, Exhibit A includes contribution to duration (CTD) analyses both by term structure and by credit quality. For instance, the Yield Curve Exposure section of Exhibit A shows the extent to which each maturity segment contributes to the sample plan s total asset duration of 6.49 or the total liability duration of 10.46. These numbers (shown in the CTD columns) also translate to dollar terms in the DV01 columns, facilitating a greater understanding of the plan s sensitivity to interest rate changes in different parts of the term structure. Similarly, a breakdown of CTD by credit quality is shown in the bottom portion of Exhibit A. We perform CTD calculations using proprietary projections of cash flow streams for the plan s fixed income assets, together with liability cash flow streams typically supplied by the plan s enrolled actuary. While projections of future cash flows are inherently imprecise (due to embedded options and other uncertainty 3

both in the assets and liabilities), our methodology allows us to gain and communicate an in-depth understanding of a pension plan s potential and actual sources of funding status change. Exhibit B shows a projection of asset and liability cash flows corresponding to the Pension Risk Summary displayed in Exhibit A. Exhibit B: Cash flow projection (sample for illustrative purposes only) Standard Deviation of Funding Status A plan s standard deviation of funding status, also called funding status tracking error, is an estimate of a onestandard-deviation change in funding status within one year. In Exhibit A, the plan s current standard deviation of funding status is 8.46%, which can be interpreted as follows: if the funding status one year from now is projected to be 94%, then a one-standard-deviation range for the funding status projection is 86% to 102% (a range of +/- 8.46% around the projected funding status). This implies a probability of approximately two-thirds that the funding status one year from now will be within the range 86% to 102%. A successfully-implemented LDI strategy should result in a reduced standard deviation of funding ratio (i.e., the volatility of the plan s funding status should be reduced). If the plan illustrated in Exhibit A were to immediately shift from 60% to 80% fixed income (with no changes to the duration of fixed income), the standard deviation of funding status would drop from 8.46% to 5.45%. On the other hand, if the plan were to immediately reduce its fixed income allocation from 60% to 40%, the standard deviation of funding status would increase from 8.46% to 11.85%. As an absolute measure of pension risk, the standard deviation of funding status is known to have substantial limitations. It assumes that investment returns are normally distributed (i.e., based on a bell curve) and it typically assumes that historical average returns, volatilities, and correlations between asset classes are applicable to future periods. These assumptions have proven to be unreliable, particularly with respect to fixed income investments. 4

In spite of its limitations, the standard deviation of funding status is a commonly used metric in pension LDI analyses. It is a fairly straightforward metric that helps a plan sponsor understand relative risk levels between the current investment strategy and potential alternative options. Change in Funding Status, $ Thousands Plan Assets Plan Liabilities Surplus/ (Deficit) Exhibit C: Funding Status Return Attribution report (sample for illustrative purposes only) Funding Status Estimated value at beginning of month $520,504 $571,018 ($50,514) 91.2% Fixed income portfolio yield/liability interest cost 689 1,912 (1,223) Impact of interest rate changes (1,756) (2,190) 434 Parallel change in Treasury yield curve (+9.6 bps) (3,238) (5,738) 2,500 Change in shape of Treasury yield curve (619) (774) 155 Change in credit spread (as implied by liability benchmark) 2,101 4,322 (2,221) Fixed income benchmark - basis differential to liability benchmark 279-279 Impact of other economic risk sources 5,883-5,883 Equity exposure 4,997-4,997 Active management 886-886 Impact of demographic risk sources - - - Liability service cost - - - Change in actuarial cash flow projection * - - - Impact of external cash flows (3,524) (3,224) (300) Plan sponsor contributions - - - Benefit payments (3,224) (3,224) - Other (300) - (300) Estimated value at end of month 522,076 567,515 (45,439) 92.0% Total Changes $1,572 ($3,503) $5,075 0.8% 2. Funding Status Return Attribution Our funding status return attribution report analyzes the key drivers of a plan s funding status changes over the prior month, quarter, or year. While the sample report shown in Exhibit C provides a comprehensive level of detail, the rows shaded in gray summarize some key data points: At the beginning of the month, the funding status was 91.2%, corresponding to a $50.5 million deficit. By month end, the funding status increased to 92.0%, corresponding to a $45.4 million deficit. The remainder of the information shown in Exhibit C attributes the change in the plan s asset, liability, and deficit values to the following sources: Fixed income portfolio yield/liability interest cost This row shows the estimated value increase in the fixed income portion of the benchmark asset portfolio, together with the estimated liability increase, attributable to interest accruals. 5

Interest rate changes These four rows show the estimated change in benchmark asset and liability values due to repricing at current interest rates (as implied by changes in the liability benchmark discount rates). As corporate bond yields increase (or decrease), the value of fixed income assets and pension liabilities will typically both fall (or rise). As mentioned previously, management of interest rate risk is a key pillar of most pension LDI strategies and this portion of the analysis helps a plan sponsor see the extent to which the interest rate hedge strategy is actually working as intended. Basis differential This row shows the impact of a risk that is sometimes overlooked when formulating LDI strategies: mismatch between the plan s investment benchmark and the theoretical liability benchmark. Unfortunately, because the liability benchmark is not itself investable, there will always be some amount of mismatch. In Exhibit C, there is a $279,000 funding status gain due to basis differential. In other words, the plan s asset benchmark outperformed the theoretical liability benchmark by $279,000 during the month. Other economic risk sources These three rows show the impact of equity returns within the benchmark asset portfolio as well as the impact of alpha (i.e., manager performance relative to the benchmark). Demographic risk sources and external cash flows For purposes of completeness, these rows show the changes in asset and liability values due to non-economic factors. Performance analysis in the Reams-managed portfolio (not shown) In addition to the total plan return attribution report shown above, for the portion of the pension plan s fixed income portfolio that is managed by Reams Asset Management, we provide a monthly report that gives additional detail on sources of over- or under-performance in the managed asset portfolio relative to our assigned benchmark (e.g., duration, sector selection, or security selection). Summary Pension plan sponsors who employ a liability-driven investment strategy should regularly monitor the strategy s effectiveness using objective, informative measurements. Reams Asset Management s investment team includes credentialed actuaries who are available to assist plan sponsors in developing LDI reports and metrics such as the sample reports shown above. 6

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 (www.reamsasset.com) or contact us directly: Todd Thompson, CFA Portfolio Manager 812.372.6606; tthompson@reamsasset.com Trey Harrison, CFA, ASA Fixed Income Analyst/Actuary 812.372.6606; tharrison@reamsasset.com Brett Dutton, CFA, FSA, EA Fixed Income Analyst/Actuary 812.372.6606; 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 2013. UMB Financial Corporation. All Rights Reserved. 7