How have pension LDI strategies evolved?
- 10 mins 11 secs
How have pension LDI strategies evolved?
Over the last decade liability-driven investing has become common amongst private pension sponsors. Jim Gannon, Senior Investment Actuary at Vanguard Institutional Advisory Services, offers insights into how LDI has evolved and the different implementation options that plan sponsors can choose from.
Remy Blaire: Welcome to Asset TV. Liability driven investment strategies have become common among corporate pension sponsors. Research and analysis from Vanguard shows that hedging long dated liabilities is expected to mitigate surplus risk to the greatest extent possible. However, how a plan sponsor chooses to pursue an LDI strategy can look very different. Joining me to offer his insights on LDI is Jim Gannon, Senior Investment Actuary at Vanguard Institutional Advisory Services. Jim, great to have you here today.
Jim Gannon: Thank you very much, Remy.
Remy Blaire: Thank you for joining me. Well, we all know that LDI has become increasingly popular over the last decade. So, can you tell me how these strategies have evolved to meet the needs of pension sponsors?
Jim Gannon: Sure. Well, what we've seen over the last decade is an acceleration of LDI within pension plans. That really started with the passage of the Pension Protection Act and Mark to Market accounting. It also happened to be at the same time when plans started to close and freeze and look towards terminating their pension plans. And so, what you have here is a group of plans that are closed and frozen, they have a more defined set of liabilities that aren't growing and they have a higher incentive to do liability driven investing. And so, they started off about 10 years ago, maybe using more standard asset based benchmarks such as the long credit benchmark or the long government credit benchmark. And that was probably good enough for the first stages of LDI, and then over time it's gotten a little more customized towards the individual plans in a way that satisfies their individual liabilities.
Remy Blaire: Jim, you've given us an overview of the evolution of LDI strategies, so I think it's very important to highlight duration. Now we know there's the opinion that LDI strategies should target the plans liability duration and looking at your research it may be more advantageous to set a duration target that's longer than that of the plan’s liability. Can you walk us through the logic of this approach?
Jim Gannon: The first thing we looked at in the paper was that pension plans typically have less dollars allocated to LDI than they have liabilities. That would happen because a pension plan might have 50% in equities and 50% in fixed income. Therefore they don't have their entire allocation in fixed income which is typically LDI. So, with their limited dollar amount, they have to figure out: “how am I gonna spend that?”. So, then we started to look at liabilities and we said: “rather than look at liabilities as a whole, let’s break these down into pieces”. And one of the most natural ways to break down the liability is by the year of expected benefits payments. We’re expected to pay this much in the first year and this much in the second year, and going on for decades actually; depending on life spans.
Jim Gannon: And so, when you do that and analyze the risk of each of those individual payments, what you find out is that the risk is very backloaded. So, to give an example, the duration of a typical pension plan might be 12 years meaning that about half of the liability value occurs before the twelfth year, and about half occurs after the twelfth year. However, what we find is that three quarters of the risk occurs after that twelfth year. So, most of the risk is occurring after that twelfth year. So, when you have that limited amount of assets you say: Where do I spend it? Do I spend it equally in the first twelve years and in the second twelve years? or do I say I’m gonna put it all in the second, beyond the twelfth year, because that is where most of the risk takes place. So, that leads plans to have a longer asset duration than they have a liability duration to get more efficiency out of their LDI allocation.
Remy Blaire: Well Jim, plan sponsors have many factors to consider when making pension risk management decisions. So, what are ways that risk can be analyzed and how should plan sponsors think about prioritizing these risks?
Jim Gannon: Okay. Well in the paper, the first part of the paper analyzed what we mentioned in the previous question, which was about long-dated cash flows, versus short-dated cash flows and how we would prioritize hedging those. The second part of the paper concentrated on ways the yield curve moves. And so, there's really three primary ways in which the yield curve moves and one is about how treasury yields move and that's the impact of interest rates. The second one is the impact of credit spreads, meaning, how does the ability of individual corporations to pay back their debt, how does that affect pension liabilities? And so that's the credit spread risk. And lastly is the yield curve risk. Meaning the yield curve doesn't just go up or down, it often flattens or steepens. Of late, it's been flattening. And so, each of those three is a certain risk that pension plans encounter relative to their liabilities.
Jim Gannon: And again, what we find is when you analyze those, they're not equal. The first one, interest rate risk, takes up about 60% of liability risk. The credit spread risk is another 30%. And the yield curve risk is only 10%. So, if we go back to the idea that we don't have $1 of assets in LDI for every $1 in liabilities, we often have 50 cents of assets because we're allocating to both equities and fixed income. Then you have to decide, "Where am I going to allocate this dollars to minimize my risks." And you really got to start with: what's the highest source? And that's the interest rate risk and then the credit spread risk. And if there's money available to minimize the yield curve risk, then we'll do that. But what we're trying to do is say, "Not all liability risks are equal and let's spend the dollars where the most risk occurs and impacts our plan."
Remy Blaire: And Jim, what type of investment vehicles are plan sponsors using and how does that vary across plans as well as asset size?
Jim Gannon: So what we see mostly are separately managed accounts, collective trusts, and then bond funds. And sometimes we see individual bonds. That's very rare. But what we're looking at is separate accounts, we think work for very large pension plans because they have enough dollars in their LDI allocation with which to gain diversification across all the issues within the long credit market and the issuers within the long credit market. But again, there has to be a lot of dollars allocated to that.
Jim Gannon: For the vast majority of pension plans, we're looking at bond funds; either collective trusts or bond mutual funds. And they can do these LDI strategies very effectively with long credit bond funds or long treasury bond funds or even funds of treasury strips to match both the duration target they need and the credit quality that they're looking for. But the important thing is to think of these as you need the diversification of the number of bonds within the fund, and that really is best done with the bond fund for your mid-size and smaller pension plans.
Remy Blaire: Designing and managing an LDI approach can be very complex. What are the different ways that plan sponsors pursue implementation?
Jim Gannon: Sure. We really see three ways in which pension plans and pension plan sponsors can manage their plans. And the first one is to, what we say, go it alone or do it in-house. And this is something that's probably only available to some of the largest pension plans who have a full-time staff with which to manage their pension assets against their pension liabilities.
Jim Gannon: This is very rare and we often think of this as occurring probably at sponsors that have, upwards of five or more billion dollars in pension assets. So, what we're talking about, there is a couple of dozen plans that really have this type of resources to do this. For the other 10,000 or so pension plans that have to look at this and manage their risks, what they're looking at is two types of arrangements. One is with a consultant and the other is an OCIO arrangement. So, the first one being a consultant, is what you're doing is engaging with an expert who will give you advice on asset allocation and advice on manager research, on how to choose managers with which to allocate your assets either to equities or fixed income. But oftentimes, that leaves the responsibility for making the choice, the final choice, back to the pension sponsor who still might not have the expertise or the know how to choose each one. And then the third one is the OCIO opportunity.
Remy Blaire: And Jim, naturally, that leads me to my next question. So, for sponsors without the dedicated time to develop and maintain an LDI approach, how can partnering within an OCIO serve as the best of both worlds?
Jim Gannon: So when we work with an OCIO client, we believe that we have to meet with them and learn about their pension plan and to come up with an asset allocation first. So, what we're doing is learning about the plan, the liabilities, their corporate risks, what their cash flows are, how they're able to pay for contributions each year, and we're deciding to come up with what the asset allocation is on a partnering with them. But it's our job as an OCIO to implement that. And so, what we're also doing is saving the time to implementation. If we were merely giving advice to them, then they would have to go implement on their own, and that might take time given the other responsibilities that corporate treasurers or treasury staff often have on their plate besides the pension plan.
Jim Gannon: And the other is individual managers. And so rather than research managers and recommend managers, we're picking and choosing managers and strategies with which they can implement their asset allocation. That's the real responsibility of an OCIO. It's the fiduciary responsibility of learning about the client to help them choose an asset allocation and then help them implement that asset allocation and save the time that it might take them to do it on their own.
Remy Blaire: Well, Jim, I know that a lot of time went into all of your research, so I appreciate your time and thank you so much for all of your insights today.
Jim Gannon: Well, thank you Remy, thank you very much.
Remy Blaire: And thank you for watching. I was joined by Jim Gannon Senior Investment Actuary at Vanguard Institutional Advisory Services. From our studios in New York City. I'm Remy Blaire for Asset TV.
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