In the midst of the current economic crisis, the most important trend among U.S. defined benefit pension plans is liability-driven investing (LDI). While pension plan sponsors always have had good reason to look at risk in terms of assets relative to liabilities — rather than just analyze asset behavior in isolation — the incentives driving them to do so have increased substantially. The trade-off between risk and return is now different.

Thanks to the sudden and swift financial downturn of 2008, more DB plan sponsors likely will take LDI more seriously, as they’ve acutely felt the pain that can come from a mismatched investment strategy. For many, this is going to create a greater sense of urgency to manage that risk in future.

An investment strategy based on nonmatching assets (such as equities) tends to provide — over the long run — superior returns compared to a strategy based on matching assets (such as bonds). That has always been true. What has changed is the way those returns and the risk associated with them affect the plan and the sponsoring corporation.

To see this, compare U.S. airlines to U.S. oil companies (chart 1). Seven airlines and six oil companies in the Russell 3000® Index have defined benefit plans. Oil companies have total DB assets of $49 billion and a combined projected benefit obligation of $59 billion. The service cost of the six corporations (the cost of the benefits accruing in 2007) is $1.6 million, just under 3% of PBO.

On the surface, that is not very different from the airline industry, as the seven airlines show total DB assets of just over $23 billion, a combined PBO of $31 billion, with the service cost of $537 million slightly below 2% of PBO.

In aggregate, the pension plans of the two industries appear quite similar: somewhat underfunded, with benefit accruals that are modest relative to existing assets.

However, the oil companies’ PBO is equivalent to about 6% of their combined market capitalization, while for the airlines, it is more than 150% (chart 2). Indeed, the unfunded portion of their PBO is equivalent to almost 40% of the airlines’ combined total market capitalization.

For some corporations and some industries — such as the airline industry — the pension issue is too big and the corporate interest too significant. LDI decisions need to be made in light of the plan and corporate dynamics.

Lengthen, reallocate, overlay, immunize: the four stages of interest-rate risk Management

At the heart of LDI lies interest-rate risk management: A realignment of the asset portfolio so that it responds to changes in interest rates more like the liabilities do. It is possible to characterize the emerging practices for managing interest-rate risk into four basic categories of behavior.

Typically the first step plan sponsors must take to reducing interest-rate risk in an asset portfolio is to lengthen: in other words, change the benchmark used for the fixed-income portfolio from an aggregate, broad-market fixed-income index (such as the Barclays Capital U.S. Aggregate Index) to an equivalent long-duration index.

This makes sense only if one is truly driven by a liability-relative perspective because, by definition, longer duration means a bigger reaction to changes in interest rates. So lengthening duration increases the volatility of the asset portfolio, and while it means reduced risk from an asset-liability perspective, it means increased risk from an assets-only perspective.

After the lengthening stage typically comes the reallocation stage. Here, plan sponsors reduce the plan’s allocation to riskier assets, which tend to come with higher (expected) returns, and reallocate those assets to fixed income.

The third stage is the overlay stage. Plan sponsors will move to this stage either because the limitations of the first two stages have been reached or because they prefer not to reduce equities or other return-seeking strategies beyond a certain point.

The defining feature of an overlay is that it uses swaps or other derivative instruments, rather than direct investment in bonds, to match the liability-return behavior. It is possible to be quite precise and to fine-tune sensitivity to each part of the yield curve as the hedge ratio increases and the broad-brush approach becomes less satisfactory.

During the fourth stage — immunization — plan sponsors take even more precise steps to lock asset behavior in to liability behavior. This is where LDI really moves beyond managing only interest rates and starts to take steps to manage the effect of the other factors. Ultimately, the solutions will move beyond investment and into the realm of risk transfer.

The majority of activity so far has fallen into the lengthening and reallocation stages. Over time, activity in the overlay and immunization stages will increase. LDI will move beyond interest-rate risk management as plan sponsors start to look more closely at other aspects of risk.

We are likely to see changes in investor preferences for the type of strategy to follow. For example, even though overlay (stage three) strategies take on greater importance as hedge ratios increase, they may well become less popular, for the short term at least. The viability of these strategies has been hurt as the financial sector has suffered, and issues like counterparty risk loom larger for investors.

And even more significant than the viability of these strategies is the lack of investor appetite. Even before the credit crisis of 2008, investors tended to favor simpler strategies over derivatives-based approaches, despite the cost and flexibility advantages of derivatives. If investors were wary of derivatives and leverage before, they will be even more so now.

Incorporating other facets of risk

The focus of LDI strategies will move beyond interest-rate management and increasingly incorporate other facets of liability risk, too. For example, in 2008, it turned out to be other risks that mattered more. Biggest of all was equity risk; plans that maintained high allocations to equity markets suffered as their asset values fell faster than their liability values. Further, counterparty risk worked its way up the list of concerns as the banking sector retrenched.

As the recession has persisted, other risks have taken on greater importance. Among these is basis risk. Basis risk is the risk that a hedging investment behaves differently than the liability it is intended to hedge. Swap-based LDI programs showed substantial gains in 2008, compared to the liabilities they were designed to hedge. This represents a good outcome for those who had such a strategy in place over that period, but arguably a good outcome based more on luck than on judgment.

It highlights the possibility that loss can occur if the spread were to move in the other direction. Not only that, it also means that these strategies carry heightened basis risk as long as the swap spread remains wide and runs the risk of reverting to a more typical level. Anybody putting on a swap-based strategy when the spread between corporate rates and the swap yield is at historically high levels would need to look explicitly at the basis risk and seriously consider whether additional steps were needed to hedge the credit component of that risk.

In short, it has become clear that it is not enough to think only of the interest-rate risk that is built into pension liabilities, but also of the credit risk. Tied to this is the question of timing — always a thorny issue, and one that is impossible to avoid when major changes to investment strategy are being considered in unusual or extreme market conditions.

LDI likely to reach a tipping point

The trend toward wider adoption of LDI programs has been growing for some time, and another potential source of growth is imminent: likely changes to how plan sponsors must calculate pension costs for corporate earnings statements.

While there have been changes to funding targets, changes to contribution requirements and changes to corporate balance sheets, there have not yet been any parallel changes to corporate earnings statements and how they report pension cost. Such reporting, for the time being, continues to be governed by FAS 87 and hinges on the concept of the expected long-term rate of return, or ELTRA.

Space prevents a fuller description of the role of ELTRA, its effect on investment strategy and the change expected in coming years. Suffice it to say that changes to this aspect of U.S. accounting standards are expected sometime between 2012 and 2014. This is likely to build the increasing momentum for LDI, leading to a tipping point as attitudes shift, familiarity increases and the herd mentality begins to favor — rather than resist — change.

Risk-transfer solutions

Many DB plans have been frozen in recent years and, eventually, these plans will need an end game. This end game is not needed immediately; as long as LDI continues to be about the management of risk, investment solutions will dominate. But it seems unlikely that, 20 years from now, corporations will still maintain pension departments to administer and manage DB plans that have been frozen for decades.

So in the fourth stage of LDI — immunizing risk — plans will begin to look not merely to managing risk but to actually transferring it.

These solutions will go beyond investment and into insurance. In today’s volatile markets, tough capital market conditions and with a weakened financial services sector, these risk-transfer solutions may seem a long way off. But the need is there.

Looking to the long term, the DB system needs a cost-effective, safe home for frozen pension plans that over time will become less and less tied to their sponsoring corporations.

Of the many open questions that remain around the future of LDI, the nature of the end game solution is one of the most difficult to predict, and the current financial crisis makes the future picture even less clear now than before.

Market conditions will drive change

Most notably, the course of market conditions over the next few years will have a strong influence.

The direction in which interest rates move will affect LDI design, because if rates drop, plans’ liabilities will be bigger — and it will be harder for sponsors to think about offloading those liabilities through LDI strategies.

But it is not only the level of interest rates that will matter; their stability will also come into play.

If interest rates continue to be volatile, this will continue to create problems for corporations and increase the perceived need for LDI strategies. Stable interest rates would have the opposite effect.

Likewise, the course of equity markets, the credit spread and general supply/demand imbalances for different types of instruments could all drive the market toward one particular type of LDI solution or away from another.

So the course of events will continue to play a large part in determining which strategies appear most attractive over time, and which particular design features are given most attention. As these developments unfurl, it is clear that LDI is here to stay. —I2

Bob Collie is the director of investment strategy for Russell Investments.