Down, Set, Hut! Quarterbacking your LDI Program Martin Jaugietis, CFA Managing Director, LDI Solutions, Russell Investments
Funded Ratios (%) The end zone is getting closer funding levels have improved allocations to LDI programs are increasing 90% Pension plan funding ratios (as at October 31, 2014) Consulting Client Universe 09/30/06 US Equity 85% Non-US/Global Equity Fixed Income 80% Real Estate Alternative Investment 75% Consulting Client Universe 12/31/13 70% -1% +6% -22% 65% US Equity Non-US/Global Equity 60% Fixed Income Real Estate Open plan (12-year duration) Closed plan (8-year duration) +16% to 43% +1% Alternative Investment Pension plan funded ratios are month-to-month change in funded status for two notional pension plans (the open plan and closed plan respectively) with projected liability cash flows based on the Standard Cashflow Generator (SCG) formula and a duration of 12 years (8 years for the closed plan), discounted using the Merrill Lynch discount curve, and asset returns based on the returns of 60% (40% for the closed plan) of the Russell Global Index and 40% of the Barclays-Russell LDI 12-year index (60% of the Barclays-Russell LDI 8-year index for the closed plan). A funded ratio of 73% at January 1, 2012 was assumed. Contributions to the plan and benefit payments were each assumed to be equal to the value of accrual of new liabilities Russell Consulting Client Universe asset allocations are equally weighted average asset allocations as at the dates given.
Glidepath What is an LDI Quarterback? How do I know my fixed income managers are all working together towards my ultimate goal which is to hedge my liability? I just paid a big lump sum, how does that affect my LDI portfolio? How do I measure success in my LDI program? An LDI quarterback is a fiduciary with discretionary investment management responsibility for ensuring your LDI program is achieving its hedging objectives Hedge ratios Interest rates are so unpredictable! Funded Status spreads I haven t got the resources to monitor my funded status and hedging portfolio daily
What does an LDI Quarterback look like? LDI Program without an LDI Quarterback External managers Long Govt/ Long Government Long Treasury STRIPS LDI Program with an LDI Quarterback External managers LDI Quarterback Completion Derivative Completion Treasury Completion Daily LDI risk system Daily cash flow management (benefit payments, contributions) Daily rebalancing, exposure management (funded status trigger) and active tilting Daily / weekly funded status and hedge ratio dashboards Quarterly reporting and attribution of LDI portfolio relative to liabilities Source: Russell Investments, example for illustrative purposes only
What are the important characteristics of an LDI Quarterback? Strategic Advice Portfolio Construction Asset Management Risk Monitoring / Reporting Portfolio Implementation Source: Russell Investments, example for illustrative purposes only
2013 2016 2019 2022 2025 2028 2031 2034 2037 2040 2043 2046 2049 2052 2055 2058 2061 2064 2067 2070 2013 2016 2019 2022 2025 2028 2031 2034 2037 2040 2043 2046 2049 2052 2055 2058 2061 2064 2067 2070 2073 Benefits of an LDI Quarterback Choosing the right liability to hedge and adjusting as required For a typical final pay plan Active Duration = 14.1 retiree lump sum offer increases duration Deferred Duration = 15.6 PBO duration = 11.2 Retired Duration = 8.7 PBO Duration = 13.2 Retiree Deferred Active Retiree Deferred Active PBO Inaccurate choice of liability to hedge may result in 10-20% mismatch in target hedge ratio Source: Russell Investments, example for illustrative purposes only
Fixed income allocation ($ 000s) Hedge Ratio % Benefits of an LDI Quarterback Monitor funded status and key hedge ratios daily, allowing responsiveness when a glide-path trigger has been hit $4,000,000 Dollar duration and hedge ratio % evolution 80% $3,500,000 $3,000,000 70% 60% $2,500,000 $2,000,000 $1,500,000 $1,000,000 $500,000 $0 50% 40% 30% 20% 10% 0% Physical Exposure Physical Government Exposure Derivatives Exposure Actual Hedge Ratio (Right-axis) Hedge Ratio Target (right-axis) Example represents the fixed income allocation and hedge ratio % for an actual Russell client employing an LDI quarterback. Hedge ratio is calculated as the dollar duration of fixed income assets divided by the dollar duration of liabilities.
Jun-02 Jan-03 Aug-03 Mar-04 Oct-04 May-05 Dec-05 Jul-06 Feb-07 Sep-07 Apr-08 Nov-08 Jun-09 Jan-10 Aug-10 Mar-11 Oct-11 May-12 Dec-12 Jul-13 Large Cap US Equity - Russell 1000 Index Small Cap US Equity - Russell 2000 Index EAFE Equity - Russell Developed Large Cap Index Emerging Market Equities - Russell Emerging Markets Index Long - Barclays Long Index Basis points Benefits of an LDI Quarterback Portfolio implementation capabilities across the whole portfolio 350 300 Total High Grade Volume Traded By Month ($ Billions)* Most months ~$250-300bn 80 70 60 Average round trip transaction costs (BP)** 250 200 December ~$175bn 50 40 30 150 20 100 10-50 0 *Source: MarketAxess **Source: Equities ($250mm portfolio) - ITG transactions cost model (Dec 31, 2013) Fixed income Barclays Liquidity Cost Scores for US TCX & Barclays US Long TCX (Dec 31, 2013)
140% 130% 120% 110% 100% 90% 80% 70% Benefits of an LDI Quarterback Tactical adjustments of LDI portfolio as market conditions dictate Extend duration to 75% hedge ratio using swaps Rolling PBO Funded Status - XYZ Client vs. Simulated Portfolio Reduce duration to 40% hedge ratio by reducing swap notional 1 Reduce swap notional to 0% and increase long credit to 100% of fixed income 2 3 4 Extend duration back to 75% hedge ratio target 32% funded status maintained over 7 years and 40%* funded status volatility reduction 60% XYZ client actual funded status Simulated funded status (65% Russell Global Index, 35% Barclays U.S. Long Index) *Funded status volatility is difference between the client s actual volatility (as measured by the standard deviation) vs. the funded status volatility using the client s former (simulated) benchmark. 32% funded status difference represents the difference between the actual funded status and the simulated funded status as of 12/31/2013. The case study provided above is from an individual Russell US Consulting client, and is provided for discussion purposes only. Individual actions and results will vary.
Consider appointing an LDI Quarterback If Your funding levels continue to improve You are allocating more to liability-hedging assets You are adopting a de-risking glide-path You are considering some form of risk transfer (lump sum, annuity purchase etc) You want to be tactical in your LDI program but haven t got a way to make investment decisions and implement with the desired speed or efficiency then consider appointing an LDI quarterback to your investment program!