In Part Three of the series titled “Manage Complexity, Deliver Clarity,” François Hélou, CFA, Director, Head of Balance Sheet Solutions Sales at BMO Global Asset Management, explains how a proper Liability Driven Investment (LDI) strategy mitigates a Defined Benefit (DB) pension plan’s unrewarded liability risks, while establishing an asset allocation that dynamically adapts a DB plan’s rewarded risks to its funding requirements and liability profile. It also discusses how an LDI strategy could also optimize the transfer of a DB plan’s balance sheet to an insurance solution through a disciplined portfolio transition.
The “Interest Rate Bet”
DB pension plans that do not hedge the majority of their liability risks take a bet on long-term interest rates. If long-term rates go up by more than the market predicts, they win (in terms of improved funding levels, all else being equal). If long-term rates go down by more than the market predicts, they lose. For most DB plans, interest rates are the biggest investment risk faced. The potential impact on plan funding from exposure to interest rates is likely to be larger and occurs more frequently than any effect arising from changes within their portfolio of growth assets.
In our second LDI series, we discussed the differences between the two types of balance sheet risk that a DB plan carries:
The Unrewarded Risks: Interest rate, longevity and, for some plans, indexation risks. These are the risks that are embedded in the plan’s design and for which the plan isn’t being compensated. The most prolific and volatile of the plan’s unrewarded risks tends to be its interest rate risk.
The Rewarded Risks: Risks the plan willingly takes as part of its asset allocation. These are the risks for which the plan should be compensated.
Why do DB plans hedge their unrewarded liability risk? For members and sponsors, the answer is the same: to reduce the volatility of the funding ratio. For members, it provides greater certainty that their promised benefits will ultimately be paid; for sponsors, it helps reduce the risk of large, unexpected cash calls and manages the level of ongoing cash contributions into the plan.
The typical “end game” for pension funds, perhaps as a pre-cursor to a full insurance buyout, is to invest entirely in a hibernation portfolio of high-quality liquid bonds, so that interest rates are fully immunized and cash flows are paid out to members regularly. This results in a relatively static funding ratio. However, most DB plans do not invest entirely in a hibernation portfolio because they cannot afford to. DB plans with a funding deficit, or even a small surplus, need to invest in growth assets to help claw back the deficit, cover pension benefit accruals and build up a funding “buffer.”
To help solve this challenge, DB plans can make use of an LDI strategy that hedges the plan’s liability risks, while adapting the plan’s asset allocation to its funding requirements and liability characteristics (including benefit accruals and drawdowns). LDI strategies should allow DB plans to invest more in bonds (or bond-like securities) without forcing them to sell their growth assets. In doing so, DB plans end up hedging their unrewarded liability risks, while staying exposed to rewarded growth asset risks. If the growth assets underperform the plan’s liability growth, the plan’s funding ratio will naturally decline, and vice versa.
Is the “Interest Rate Bet” Prudent?
A DB plan’s greatest concentrated risk is the interest rate risk embedded in its liabilities. As we stated in the previous issue, for a DB plan with a 16-year duration, a 1% decline in its going-concern discount rate affects the plan’s accounting valuation in a way that is equivalent to approximately 16% decrease in its asset value.¹ By all measures, this is a significant exposure and, while it may seem an improbable move, a decline in excess of 1% in 10-year Government of Canada yields has in fact occurred twice in the past five years, once between July 2014 and July 2016, and once between October 2018 and the end of June 2019.