The Downsides of LDI

In other investing situations, generating the best possible returns is the goal. But a defined benefit (DB) plan’s assets must meet specific, future obligations, and LDI helps it do so.

“Liability-Driven Investing: Investment Strategy vs. Business Strategy,” a report from the Brandes Institute, delineates pros and cons of LDI for plan sponsors. LDI considerations are relevant now, the paper contends, because of recent requirements that have made plan losses more visible. At the same time, last year’s positive returns inspired many plan sponsors to consider adopting LDI and securing those gains.

On the positive side, LDI protects against short-term equity price volatility and raises exposure to longer-duration bonds that are more closely correlated with interest rate changes than equities. The downside: Some long-duration bonds are in short supply, possibly requiring leverage and thereby increasing counterparty risks, the paper says. At the moment, interest rates are still extremely low, which means LDI is expensive to adopt.

To match assets with future liabilities, there are two general approaches, Bob Schmidt, the manager of the Institute, tells PLANSPONSOR: duration matching and cash flow matching. “For example, plan sponsors with a 15-year horizon for paying pension benefits may invest in bonds with a duration of 15 years,” he says.

“This would help protect the plan from adverse effects due to interest-rate moves,” Schmidt says. “If rates declined, assets and liabilities likely would increase. If rates rise, assets and liabilities would decline. In theory, the assets and liabilities are matched.”

In cash flow matching, plan sponsors, might seek to deliver a specific dollar amount to retirees 25 years in the future, Schmidt explains. “While there’s more certainty in matching these projected cash flows with bonds, the cost to do that right now, given the near record-low rate environment, is very expensive,” he says.

Another member of the Brandes Institute, Bob Maynard, chief investment officer at Public Employee Retirement System of Idaho, expresses concern with the short-term accounting conventions used in LDI. These conventions, one to five years, are at odds with the long-term behaviors of investment markets and member lifetimes, which run along a time horizon closer to 10 to 50 years, Maynard says. These short-term conventions can change and they have done so frequently in just the last 20 years, he notes.

“For example, federal legislation now allows the use of smoothed corporate interest rates as a discount rate for some purposes,” Maynard says. “Such changes can make current long-term LDI strategies inappropriate.”

According to Robert Willis, CEO and chief investment officer at Willis Investment Counsel, behavioral biases may be driving adoption of LDI even when the strategy is not optimal for a plan. In the last 10 years, Willis says, “LDI was not a necessary risk management strategy for all or even most DB plans. For those who were able to practice patience and discipline and adhere to a traditional asset-allocation structure, the less complex traditional model was as effective and arguably more effective,” compared with relatively more complex approaches. 

Plan sponsors should consider the following LDI risks:

• It may be harder to accurately forecast future liabilities than investors realize.
• Today’s cost to immunize a portfolio through LDI is high.
• If using bonds to immunize a portfolio, it can be difficult to find them with durations long enough to match liabilities. Hedging techniques can be used to bridge the gaps, but that creates counterparty and liquidity risks.
• Investment approaches that have featured bonds have done very well the last 20 to 30 years in part because interest rates have fallen sharply. If the next leg in the interest rate cycle is higher, bond-heavy LDI strategies may experience sharp, short-term price declines.

The Brandes Institute is a division of the San Diego-based Brandes Investment Partners, with assets under management of $27 billion.  

“Liability-Driven Investing: Investment Strategy vs. Business Strategy” can be downloaded from the Brandes Institute’s website.