LDI 2.0

Traditional liability-driven investing (LDI) for defined benefit (DB) plans involved moving assets from equities to fixed income—usually bonds—as the funded status of the plan grew. The idea was to preserve the funded status that was reached while trying to continue to improve it with return generating investment vehicles.

However, Conning’s Annual Pension Review 2018 found that in the last few years, most of the shift out of equities was a move to asset classes other than fixed income. The report says, “A large part of the equity drawdown has been reinvested in alternatives and real assets, with smaller plans leading the charge.”

Sean Kurian, a managing director and head of institutional solutions at Conning, based in New York City, says it’s not that LDI is lacking, but plan sponsors are evolving in their understanding from “LDI 1.0,” as he calls it. “There’s a better appreciation of risk in interest rates and what plan sponsors can invest in to get a better match of assets and liabilities,” he says.

Kurian explains that for a DB plan to get out of a deficit, there are only two ways: make contributions to the plan or get returns. By investing in alternatives and real assets, plan sponsors can increase diversification. Just investing in equities is a concentrated risk position.

“A sophisticated hedge fund strategy or private equity investment may outperform traditional equities,” he says. “The way we think about portfolio construction for pension plans is to have a hedge portfolio focused on managing liability risk, then have a return-seeking portion that creates excess returns vs liabilities—just don’t put all your eggs in one basket.”

Kurian adds that diversification means the overall return seeking portion of the portfolio may be more profitable; however, it may just mean a 5% or 10% move from traditional equity. It’s not a large allocation shift on an individual plan-by-plan basis.

Chris McGoldrick, head of defined benefit delegated investment solutions at Willis Towers Watson, based in Philadelphia, agrees that it’s not that “LDI 1.0” is not working, it is just not working as efficiently as it could, driving plan sponsors to be quick to move to respond to changing market conditions.

Willis Towers Watson advocates for a “total portfolio strategy”—instead of thinking about each asset class separately, think about how they work together. Plan sponsors should think about the interplay between asset return and hedging to maximize outcomes

Like Kurian, McGoldrick says this means more diversification. “In the return seeking part of the portfolio, investors think if they diversify between equity managers, they are diversified,” he says. “But, they need to think about other asset classes—high yield bank loans, credit, real estate investment trusts (REITs), infrastructure, hedge funds and alternative beta hedge fund type strategies.” McGoldrick adds that these asset types are not as correlated with the equity market or corporate growth and will perform well in different markets.

“On the fixed income side, it depends on the DB plan’s liability and how well-funded it is,” McGoldrick says. “Plan sponsors should think about more than high credit bonds. They should be more efficient and think about government exposures or Treasury Separate Trading of Registered Interest and Principal of Securities (STRIPs).”

A Willis Towers Watson Insights article says, “For plan sponsors, the acceptable range of portfolio outcomes, and consequently the appropriate sizing of various return drivers, is a function of plan characteristics and objectives. A fully funded, frozen plan considering annuitization in the near term will have a lower return objective and will need less exposure to return drivers with greater variability than a poorly funded plan attempting to close a deficit over the long term. The shorter the time horizon, or the lower the return objective, the greater the need for diversification.”

According to McGoldrick, “Another thing to keep in mind is a plan’s changing liability profile. It will change over time as retirees start getting payouts. Plan sponsors need a strategy to adjust to that, and it has to be done in a risk-controlled way to avoid surprises”

That’s why Kurian warns that DB plan sponsors have to be careful to not overload on return-seeking investments because they also don’t want to be a seller in a bad market when they need liquidity to pay retirees. However, he notes that while liquidity needs will increase as retirees withdraw, plans may not have a large liquidity need if they structure their hedging portfolios more directly against liability cashflows.

According to Jeff Whitehead, head of client investment solutions at Aegon, based in Cedar Rapids, Iowa, with many pension plans facing the challenge of meeting regular cash flow requirements, cash flow-driven investing (CDI) is growing in popularity. He explains that CDI is an investment approach focused on delivering a consistent, reliable stream of cash flow to meet the obligations of an organization and plan sponsors may want to consider a CDI solution to meet short-term cash flow needs.

“For plan sponsors, the need is the same: a programmatic and systematic approach to meet current and future liabilities,” Whitehead says. “However, different cash flow needs require tailored cash flow solutions and cash flow-driven investing is an option because it is highly customized.” He explains that no two CDI portfolios should be identical, and each CDI portfolio can be tailored to specific circumstances, taking into consideration cash-flow predictability, expected contributions, risk tolerance, liquidity needs, tax considerations and the overall objective of the portfolio.

According to Whitehead, the best use of CDI for corporate plans is in conjunction with LDI. He says, especially for plans approaching fully funded status—whether the plan sponsor intends to keep the plan in hibernation or is ultimately planning for a full risk transfer—plan sponsors need to focus on the plan’s funded status and having CDI on the front end can be helpful.

“I think CDI works for other plans as well, especially for public funds or multiemployer plans, church plans, hospitals—any plan that doesn’t discount at the AA rate. Many of these plans are not as well-funded and tend to focus more on their expected return on assets,” he adds.

CDI creates enough cash flow month-by-month or quarter-by-quarter to fund expected outflows so investment committees don’t have to do that every quarter or whenever they meet. Whitehead explains that with CDI, a laddered portfolio is created to provide cash flows that mature at the right times to meet outflows. “You’re trying to have the right amount of money every month or quarter so payments can be paid without ever having to sell assets,” he says.

“DB plan sponsors don’t want to be a forced seller in a chaotic market. If they use CDI, they decide when to sell assets. They can sell stocks when they desire,” Whitehead adds.

CDI can be tailored to different situations. For example, if a plan has far more retirees than active or terminated, vested participants, it is more cash flow negative needs more money. Other plans may not need as much.

In conjunction with LDI, CDI is part of the fixed income allocation. Whitehead explains that the more CDI plan sponsors use, the more duration they will have to get from the LDI portfolio to match liabilities. For example, if the liability duration of the plan is 12 years and the plan sponsor uses a portion of the fixed income allocation for CDI, it will have to use longer duration vehicles to match the 12 years.

“LDI continues to evolve, and after the financial crisis [of 2008/2009], most thought of using long duration bonds to hedge interest rates. Through the years, DB plans have become more sophisticated and better-funded, and plan sponsors realize there are better ways to hedge,” Whitehead says. “CDI is another step along the journey that makes matching liabilities better. CDI in conjunction with LDI matches short-term cash flow needs while maintaining protection for needs further out.”