LDI

Liability Driven Investing (Part Three): Capital-Efficient Investing

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.
July 2019

François Hélou

Director, Head of Balance Sheet Solutions Sales, Institutional Sales & Service

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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:

  1. 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.

  2. 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.

LDI should allow DB plans to invest more in bonds (or bond-like securities) without forcing them to sell their growth assets. DB plans end up hedging their unrewarded liability risks, while staying exposed to rewarded growth-asset risks.

Not hedging the interest rate risk embedded in the plan’s liabilities is the “Interest Rate Bet” that many DB plans make with the view that since long-term rates are so low, they can only go up. Although this view might have merits, we don’t believe it to be prudent for the following reasons:

  • Long-Term Trend: Pension plans have been stating that rates are too low for a long time and yet rates kept going down for decades, not only in Canada but globally as well (illustrated in Chart 1). There are examples of rates staying low (by today’s standards) for very long periods of time, such as in the 1950s and 1960s, and in Japan today. An interest rate trend similar to Japan’s is now being observed in the Eurozone. As we explained in the first issue of this series, this long-term trend results from a combination of global economic and demographic factors that are unlikely to reverse themselves in the near future. Negative interest rates that have prevailed for several years amongst some Central and Northern EU sovereign issuers have now spread to France, which issued its first ever 10-year bond at a negative interest rate (€ 4.972 billion @ -0.13%) on July 4, 2019, along with a 15-year and a 30-year bond, each carrying a coupon rate below 1%.

Chart 1: 10-Year Government Yields (%) February 1, 1989 to June 28, 2019

Chart 1: 10-Year Government Yields (%) February 1, 1989 to June 28, 2019

Source: Bloomberg.

  • Market Expectations: The yield curve expresses the market’s best guess of future interest rates. The inversion of the Canadian yield curve out to nearly 19 years as at June 28, 2019 (illustrated in Chart 2), up from 13 years on May 30, 2019, is indicative not only of market expectations for future lower long-term interest rates, but also of the increase in the length of time during which interest rates are expected to keep declining. The deepening inversion of the Canadian yield curve is consistent with the development of the U.S. yield curve. Yield curve inversions have historically been associated with changes and downturns in the business cycle, for example in 2005, 2006 and 2007. The fact that the yield curve is inverting so significantly at a time of historic low interest rates begs the question as to whether it is prudent to bet the DB plan’s funding requirements on the belief that rates will go up simply because they declined so much in the past few years.

Chart 2: Canadian Government Yield Curve - June 28, 2019

Chart 2: Canadian Government Yield Curve - June 28, 2019

  • Asymmetric Payoff: The types of risks that a DB plan carries gives the “Interest Rate Bet” a risk profile that is skewed against the plan sponsor. The upside benefit to a sponsor, due to increases in long-term interest rates, becomes increasingly limited as the plan’s funding position improves. On the other hand, the downside risk to the sponsor, due to a decrease in long-term rates, is not similarly limited. Furthermore, a poor market environment can cause a decline in long-term interest rates, combined with a fall in growth assets. This means that the resulting negative effect on the DB plan’s funding position is usually aggravated by the negative effects of its “Interest Rate Bet” during times of economic hardship.

 

The Effect on DB Plans’ Balance Sheet Volatility

Traditionally, a DB plan’s asset allocation consisted of a diversified balanced strategy whose growth was targeted a) to eliminate the plan’s future funding requirements in excess of the regular pension contributions; and, b) to keep pace with the growth in the plan’s liabilities. This traditional “asset-centric” strategy usually had little correlation with the plan’s liability risks, and more specifically, its interest rate risk. This was either because of the belief – or the hope – that the plan’s asset growth would more than offset negative fluctuations in its liability value, or the belief that the current level of interest rates weren’t conducive to hedging the plan’s duration (or a combination of the two).

This “balanced” strategy can add significant volatility to Canadian DB plans’ balance sheets. For the third quarter of 2018, Aon reported a Median Solvency Ratio of 103% and a Solvency Shortfall of 42%, whereas it reported a Median Solvency Ratio of 95.3% and a Solvency Shortfall of 61.5% in the fourth quarter of the same year.² A decrease of nearly 8% in the Median Solvency Ratio and an increase of nearly 50% in the Solvency Shortfall in just three months of poor market performance corresponded with a decline in long-term interest rates. The strong market recovery in 2019 wasn’t accompanied by higher long-term interest rates, which stymied the recovery of DB Plans’ balance sheets. For the second quarter of 2019, Aon reported a Median Solvency Ratio of 99.3% and a Solvency Shortfall of 51.8%,³ both measurements being better than the last quarter of 2018, but significantly worse than the levels reached in the third quarter of that year.

 

Capital-Efficient LDI: A Prudent Asset Allocation for a Balance Sheet Strategy

A prudent asset allocation incorporating a capital-efficient LDI strategy aims to mitigate the DB plan’s unrewarded liability risk, while optimizing its growth asset strategy to meet its funding requirements. For most pension plans, these are two conflicting goals. Investing assets in government and corporate bonds matches the performance of their liabilities, but often entails reducing investment in growth assets and hence giving up the expectation of higher long-term returns. This creates a dilemma for pension plans.

Capital-efficient LDI strategies offer new options to DB plans: they allow the plans to hedge their liabilities, while still providing exposure to growth markets such as equities. A capital-efficient LDI strategy could, for example, offer a portfolio of high-quality liquid bonds combined with exposure to Canadian, U.S. and global equity markets using exchange-traded equity futures.

Capital-efficient LDI strategies offer a new option to DB plans: they allow the plans to hedge their liabilities while still providing exposure to growth markets such as equities.

The ability to select a synthetic portfolio of growth assets, such as equities, allows a DB plan to “mix and match” its asset allocation according to its risk appetite, its funding requirements, and its liability profile. The DB plan is now optimizing its rewarded risk, while simultaneously hedging its unrewarded liability risk.

An example of a capital-efficient LDI strategy using a synthetic portfolio of exchange-traded equity futures and a portfolio of fixed income LDI hedging assets is shown below (Chart 3):

Chart 3: Full equity exposure + liability hedging

Chart 3: Full equity exposure + liability hedging

For illustrative purposes only.

Efficient Transition to an Insurer

Capital-efficient LDI strategies can go a long way in helping DB plans to reach full funding. An increasing number of Canadian DB plans target an insurance-based Pension Risk Transfer (PRT), such as a buy-in or a buyout. An LDI solution is the first step toward the PRT end-game, since LDI will help stabilize the funding ratio, reduce balance sheet volatility and create a more certain path toward a PRT.

However, the risk to the sponsor does not end here, as the transition itself can still present several headwinds. Transferring assets, typically in cash, to an insurer gives rise to four types of risks:

  • Timing Risk: Results from a period of one to four weeks after a plan sponsor contractually accepts the PRT price during which the sponsor liquidates the plan’s asset portfolio and sends the cash proceeds to the insurer. During that time, the sponsor is exposed to market moves that could negatively affect the value of the plan’s asset portfolio.

  • Basis Risk: Results from the differences that exist between the plan’s fixed income portfolio and the securities that the insurer will purchase to hedge its PRT obligation.

  • Liquidity Risk: Results from the availability of the securities that the sponsor needs to sell in order to purchase the PRT and the adverse market effect that such a sale, especially over a period of one to four weeks, might have on the selling price of the securities.

  • Transparency Risk: Results from poor communication with the insurer regarding the DB plan’s members-related data that leads to a worse PRT pricing.

An efficient balance sheet solution could mitigate these risks through proper management of the PRT process. This would involve investment strategies such as:

  1. Management of portfolio liquidity, to ensure no capital is locked away or at risk;

  2. Gradual portfolio positioning to reflect the hedge that the insurer needs for the PRT, including co-ordination of market trading to minimize value slippage and volatility; and,

  3. Use of transfer-in-kind facilities when moving securities from the LDI portfolio to the insurer.

In conclusion, incorporating a capital-efficient LDI strategy for a DB plan allows the sponsor to better determine and coordinate the path to its plan’s end game by avoiding the “Interest Rate Bet,” while setting a level of growth assets that is suitable to the plan’s funding requirement and liability profile. A capital-efficient LDI strategy also helps the sponsor achieve a cost-effective transition toward its plan’s final de-risking stage.

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¹ Ignoring convexity – all else remaining equal.

² Aon, “After year of record highs, financial health of defined benefit pension plans ends 2018 in decline,” January 4th, 2019.

³ Aon, “Pension plans’ financial health flat as strong asset returns strength fail to stem impact of falling bond yields,” July 11, 2019.

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