This doesn’t mean that LDI is a fixed income strategy that should rigidly match the pension’s asset duration with its liabilities. Implementing an LDI strategy requires that a sponsor first establish its long-term plan to progressively reduce investment risks based on its funding level. If and when the plan’s funding position improves, the LDI strategy adapts to reflect the pension sponsor’s progression toward its de-risking end goal. For some plan sponsors, that de-risking end goal is a pension risk transfer to an insurance company or a hibernation portfolio with an asset manager.
DB plans in a large underfunded position typically seek to maximize growth by investing in equities. This, however, exposes the sponsor to volatility in its plan’s funding levels which, as we have recently seen, might be severe in case of a significant equity market decline, and especially if it is accompanied by a drop in long-term interest rates. Furthermore, many provincial pension reforms have recently imposed additional going-concern funding requirements based on a DB plan’s equity allocation. Capital-efficient LDI strategies could remove unwarranted risks from these DB plans by replacing a portion of its equity allocation with an equity replication strategy, thereby managing the plan’s liability risk and still allowing exposure to growth assets.
DB plans approaching full funding may begin to de-risk their investment strategy. The plan will probably need to continue holding growth assets at this stage, albeit through a more traditional LDI strategy, and/or reduce its allocation to the equity replication strategies.
DB plans exceeding full funding will pick up the pace of their de-risking strategy. This may include progressively selling growth assets to invest in a liability-matching strategy. For those sponsors seeking full de-risking through an off-balance sheet solution, the LDI strategy will progressively evolve with the DB plan, through systematic annuitization or portfolio hibernation, until it reaches the required funding levels that allow it to transfer the pension risk to an insurance company.
The Pension Regulatory Considerations
As a sponsor progresses through the de-risking journey, it is important for its LDI manager to incorporate the relevant regulatory parameters in its investment decision-making. As we briefly mentioned above, recent provincial regulatory changes can affect the DB plan’s going-concern funding level, either through its asset allocation between “fixed income” and “non-fixed income” or its level of duration-matching between assets and liabilities.
Furthermore, the DB plan’s asset allocation will determine its actuarial going-concern discount rate, which in turn affects the value of liabilities on which the plan’s funding is based. An extremely low-risk asset allocation might decrease the plan’s going-concern funding requirement, but only at the cost of lowering the going-concern discount rate and increasing the present value of liabilities.
Stay tuned for our next article in the Spring 2019 Edition of Institutional Quarterly in which we discuss insurance-based pension de-risking strategies and how they can fit with a DB plan’s risk management implemented through a Liability Driven Investing
An award-winning² provider of LDI solutions with LDI industry endorsements globally, BMO Global Asset Management brings its LDI expertise and innovation to more than 485 clients, managing over $167 billion in pension liabilities.