Pearls Of Wisdom

Liability driven investing explained by Jay Vivian of IBM retirement funds

By now, the basics of pension liability-driven investing (LDI) are pretty well understood: There’s downside risk because assets might go down, but even more if liability discount rates go down. The basics are things like really understanding how your liabilities will worsen if rates go down and alternative ways to hedge.

But LDI is not a free lunch, you can lose a ton of money on it, and as they say, it has a lot of hair on it. Here are a dozen not-so-basic considerations that really should be thought through if you want to do LDI right:

#1) Make sure you’re using LDI for the right reasons and communicating and documenting those reasons. Doing it just to reduce the likelihood of big future contributions could be questionable, because that could be interpreted as a plan sponsor consideration not “solely in the interest of the participants and beneficiaries,” as required by ERISA. Better to use LDI to improve the future ability of the plan to pay benefits. Similar outcome, but an important distinction your lawyer will appreciate.

#2) LDI needs to be an integral part of your investment strategy, not an add-on. It needs to be evaluated in a full asset liability model (ALM) context. Not all ALM providers are equally capable, so make sure yours does it right. You can include predefined triggers to change hedge parameters (aka dynamic asset allocation) as part of this, but they need to be part of the strategies your ALM tests, not just add-ons.

Also: Make sure your ALM inputs and outputs are properly specified. Understand your time horizon really well—it’s great to say you’re a long-term investor, but if your CFO is checking funded-ness quarterly, I doubt you actually are. Inflation should be an independent variable from your other rate specifications. Explore in detail how your liabilities are valued. Make sure your LDI instruments are properly valued by the model. Be very crisp on your objective functions—consistent with #1 above, I’m partial to measures that reflect your ability to pay benefits in very poor market conditions, e.g. during a 1-in-50 downside event. (Avoid identifying an event as “worst case”—do not use this phrase, especially when presenting to senior management. There’s no such thing, and using this phrase gives people (maybe even you) a false sense of security. You imagine you’ve bounded your possible downside, and you haven’t.)

#3) Carefully consider how hedged you want to be. For several reasons, it may not be 100%. For one, your forecast of the correlation between stocks and bonds may impact it, because that helps determine how much hedge your stocks might provide. It’s not intuitive, but the farther away from 0.00 your stock-bond correlation, the more or less your stocks might hedge you. As in #2 above, look at this holistically. When you’re doing LDI, spend extra time on this correlation—that single input can drive big program size changes.

#4) In line with ensuring that your ALM is holistic, it’s particularly important with LDI to look at your true, comprehensive liabilities. You might think this is the number in your annual report, but it may not be. Look your actuary in the eye and say, “Forget the regulatory reporting—what’s your absolute best guess as to what benefit checks we’ll end up writing over the next 50 years based on everything you know about us today?”

Include your best guess on salary growth, population growth (if relevant), and pension increases you might give retirees. You may not be committed to give increases, but are you sure your plan sponsor won’t give one if inflation is 10%+ for a couple of years like it was around 1980? What if retirees are picketing headquarters saying that their purchasing power has dropped 30%? If you’re a union plan, have you included increases beyond those in your current contract? And, don’t forget, cash balance plans accrue even if closed and frozen.

#5) I’m not a market timer, but timing is everything. Interest rates are at historic lows and “can’t go any lower.” If they really can’t go lower, is this the time to put on positions that could cost huge amounts of money if they go up? If rates do go back up (and they probably will, someday) everyone will remember (true or not) that they predicted it and that no one (especially you) would listen. Don’t aggressively champion interest-rate hedging when rates are as low as they are. There are good reasons to do LDI, but they need to be agreed on by the entire organization with a comprehensive understanding of the broad context of the decision.

#6) Ensure you manage regret risk.You (and your management) might think you understand that LDI is a balance of risk and return, but consider a +300 basis point rate move. That’s great news because your liabilities collapse, right? But how’s that going to play with the new CFO who wasn’t in on the LDI implementation? Yeah, you’ll tell her the program behaved like it was supposed to, but when you have to pay Wall Street swap counterparties 25% of the value of your fund because you had that damn LDI hedge on, will she sign the checks quietly? Maybe, maybe not. Be sure to explicitly discuss what happens, in dollar terms, if rates rise a lot. Make sure all the senior players understand that writing big checks is not unlikely. Make sure this gets into your committee meeting minutes. Brief new executives as soon as possible.

#7) Be clear in advance how you’ll benchmark LDI. Any investment program should have a crisp, clear benchmark. Hopefully, your record keeper is already providing total fund return and a total fund benchmark. After you implement LDI, will it be included in both? How will they be calculated? If you’ll leg into LDI, how will you leg into your benchmark? This is messy and can be hard to do and to explain. If it’s liability based (and that’s what the “L” in LDI stands for, right?), how and when will your benchmark constructor get liability info, and from whom? These are not easy questions.

#8) Be clear in advance on how you’ll rebalance. Adding LDI investments typically adds at least one degree of freedom that can really complicate rebalancing, and it can create big liquidity problems.

#9) Speaking of that, think long and hard about liquidity. In normal times, this may not be an issue, but in abnormal times, it can be a very serious one. Things can look good overall if rates rise: liabilities sink, you’re looking nicely funded, but where will you raise the cash to pay your LDI bills? Remember: Everyone else with LDI is in the same boat, trying to sell the same stuff you are to pay their LDI bills.

#10) Take great care if you’re using ISDA or similar agreements. If you don’t know what an ISDA is, thank your lucky stars, unless you’re using them without knowing what they are, in which case you should leave town. Don’t let your counterparties draft your T’s&C’s “as a favor to you”—hire specialized, experienced (which equals expensive) counsel to do this for you. Be sure you and your team are capable of making the rapid-fire complex decisions that will come in a crisis. Consider hiring someone non-conflicted to do it for you.

#11) Along the same lines, ensure that you have sufficient, capable staff for LDI. You might not want to use your bond team for this. They may not fully understand pension liabilities, inflation, accounting, and liquidity—and if you have an LDI crisis, they’ll be severely distracted by the impacts the same crisis will create in their day jobs.

#12) Governance and communications are very important in LDI. This includes ensuring that your management is involved in strategy development, documentation, implementation, oversight, and updates. It includes briefing new members of management as soon as they come on board with what plans you have in place. It includes good minutes of committee meetings discussing LDI, especially those discussing large cash outflow and/or trigger scenarios. It includes reviews, at least annually.

So there’s some of the hair on the LDI process—maybe even a hairball’s worth. If you’re thoughtful and cautious, you should make it through. Good luck.