LDI is no wonder drug for investment ills
Experts say focus on liabilities shouldn't come at expense of other parts of portfolio
Thao Hua
LONDON — Often sold as a panacea for removing pension funds' asset and liability mismatches, liability-driven investing is more likely to relieve the symptoms than offer a cure, according to experts in the U.S. and U.K.
Certain types of risks can be hedged or managed effectively, but institutional investors should not count on LDI to solve all of their problems, said Nancy Everett, president and chief executive officer of New York-based General Motors Asset Management. GMAM manages $166 billion overall, including General Motors Corp.'s $114 billion pension plan, which launched an LDI investment framework in 2003.
Michael Peskin, New York-based managing director and head of the Global Pension Solutions Group at Morgan Stanley, added: "While almost all views on (LDI) are probably healthier than the paradigm that preceded it, it's not enough to care about certain risks, such as interest rate risk, and not pay attention to the rest of your portfolio."
Before the LDI movement, most corporate pension plan sponsors focused on maximizing returns on assets. But investment approaches that ignore the liability side are no longer viable in a mark-to-market environment because corporate plan sponsors could find themselves with heavy pension deficits that ultimately affect share prices, consultants said. As a result, many sponsors have implemented or are considering an array of strategies under the LDI umbrella that are aimed at better correlating their assets with liabilities. These range from an all-bonds strategy matching future liabilities to hedging interest rate risks while maintaining a higher-alpha underlying portfolio. But what they all have in common is a focus on risk management.
Not all LDI strategies are created equal, however, and the potential pitfalls can intensify rather than reduce the mismatch between assets and liabilities. These pitfalls include: not having enough alpha-seeking investments over time to cover funding shortfalls; ineffective ways of controlling certain investment risks under more volatile market conditions; and failure to recognize the shortcomings of LDI strategies, according to pension executives, consultants and managers.
Therefore, plan sponsors need to constantly revisit their investment strategies and fine-tune them so what they're doing still makes sense, said Andrew Dyson, managing director and head of institutional business for Europe, Middle East and Africa for BlackRock Investment Management Ltd., London.
"The concept of using derivatives and other strategies for hedging risk in terms of liability management is increasingly well understood," Mr. Dyson said. "The next stage is thinking about how you can create returns and manage the risk related to the creation of those returns in this framework."
Alpha challenge
One of the biggest challenges in implementing LDI centers on alpha. Early adopters of LDI strategies say it is an ongoing struggle to find the right balance between reducing volatility and achieving returns that are high enough to secure future liabilities.
For example, GM's LDI strategy is heavily focused on hedging interest rate risk and diversifying its portfolio with alpha-chasing alternative investments. At year-end 2005, the latest date for which data are available, 7% of GM's total pension assets was allocated to real estate and 14% was in other alternatives, including hedge funds. Equities comprised 47% of the overall portfolio, and another 32% went to bonds and other fixed-income investments. The fund earned a 13% investment return and was overfunded by $7.5 billion, or 8.25%.
Dwindling returns?
Fund officials are concerned that with more investors using alpha-generating programs, the returns might dwindle. "There's currently nothing on the horizon in particular that we see as being a threat," GMAM's Ms. Everett said. "The question remains that with more alpha programs, is the alpha still going to be there? How are we going to structure it appropriately? We worry about those things all the time."
William Quinn, chairman and CEO of American Beacon Advisors, Fort Worth, Texas, which manages $58 billion, including about $18.6 billion in pension assets for American Airlines Inc., said American's LDI strategy dates back 25 years and involves about $8.5 billion in defined benefit assets. Since its inception, the strategy has gone through several transformations to reflect market conditions and improve the funded status of the pension plan.
The portfolio went from a fully immunized strategy using bonds in 1982 to one that now has more potential for alpha with 30% of assets in U.S. equities, 20% in international equities and 10% evenly split between private equity and emerging markets. Another 40% of the portfolio is invested in fixed income.
"During the late '80s, when interest rates declined to 10% and … bonds were called, we realized that the immunization didn't work," he said. "Thus, we implemented a dollar duration immunization strategy.
"We revisit this every year, and in fact, we're in the midst of doing that now to see if there's a smarter way to do this," Mr. Quinn said. Considerations include increasing the private equity exposure to 10% and further reducing fixed income.
"We are considering whether 40% is the right number, and we may be looking to reduce that, especially if interest rates are around 5%. But could we withstand the volatility?"
Among the risks that can be managed and are most likely to be considered in an LDI strategy are interest rates and inflation. But hedging these risks might not be enough, Morgan Stanley's Mr. Peskin said.
For example, such an investment strategy could leave the portfolio highly exposed to equities. If there's a surge in inflation, interest rates could go up while the equity markets fall.
"In that world, pension funds that have taken this route (of using swaps to hedge interest rate risk) face a liquidity squeeze," Mr. Peskin said. "They have to pay up the collateral to meet the swaps, so they'll have to sell equities after equities have gone down in price. This could exacerbate the resulting drop in funded status."
Another scenario may involve a portfolio that's too heavily invested in bonds.
"If you're seeking to match (assets and liabilities) to the last penny, you're putting in a lot of spurious effort and may find yourself in a degree of trouble," said Ralph Frank, senior investment consultant who specializes in LDI strategies at Mercer Investment Consulting, London. "One never knows when something is going to come out of left field."
In 2000, Boots Co. PLC, Nottingham, England, sold off its entire £1.4 billion in equities holdings and attempted to immunize 100% of its portfolio by investing in long-dated and inflation-linked bonds and interest-rate swaps. Two years ago, the company announced it would move away from that strategy and invest 15% in other asset classes. Spokesman Donal McCabe declined to be specific about which asset classes, but the announcement at the time referred to real estate and private equity as possibilities.
"The rationale was that we were never going to be able to entirely match our liabilities with bonds," Mr. McCabe said. "In the longer term, we felt that a better investment plan would be to include other, higher-return investments."
'Unmanageable'
Other risks prove practically unmanageable, according to LDI experts. They include:
• the increasing average life span of retirees has meant pension costs have also risen;
• regulatory changes, such as the Pension Protection Act, may significantly alter the cost of providing a pension;
• accounting changes such as mark-to-market requirements have affected the way pension assets and liabilities can be considered in corporate finance;
• tax rules are also subject to change, potentially affecting pension liabilities;
• sponsor risks include bankruptcy and other business-related changes; and
• different agents working for the pension plan also pose potential risks. For example, counterparties providing swaps in an LDI strategy might not be around in 20 to 30 years.
Addressing longevity
Most plan sponsors using LDI strategies "don't really address longevity and all of those other things out there," said Alan Brown, London-based head of investments at Schroder Investment Management Ltd.
Before joining Schroders in 2005, Mr. Brown was chief investment officer at State Street Global Advisors, Boston, and was instrumental in developing LDI strategies for that firm. One of his first tasks when he arrived at Schroders was to implement an LDI strategy for the company's own £465 million ($907 million) pension plan.
While Schroders' LDI solution differs from General Motors', both rely heavily on relatively illiquid alternative investments for alpha. Schroders has about a 30% exposure, including 15 percentage points in real estate, six percentage points in hedge fund of funds, five points in private equity and two points each in a global corporate debt fund and a Japan long-short strategy.
"We took the view that real yields were so low that locking ourselves in 40-year swaps would be a very expensive decision," Mr. Brown said. "It would lower likely returns significantly and therefore raises (future) costs significantly.
"The obsession is over accounting risks, and you may be able to reduce that, but you won't get rid of all the real risks. The noise level around them is rather high."