LDI = Let’s Do It (Now Is the Time to Make Improvements to Your LDI Portfolio)

By: Andrew Hunt, CFA, FIA and Katie Wadley

Corporate pension plan investment strategies are always evolving. Market conditions and funded ratios have changed a lot in the last couple of years. With this as a backdrop, Andy Hunt, senior investment strategist, and Katie Wadley, institutional client director at Allspring Global Investments, discuss why now is the time for investors to consider making improvements to their LDI (liability-driven investing) portfolios.

Andy Hunt: It’s an exciting time for pension plan investment. We’ve been waiting years for the current market’s blend of conditions and there are new and improved ways of getting things done.

Katie Wadley: That’s Andy Hunt, senior investment strategist at Allspring Global Investments. I’m Katie Wadley, institutional client director at Allspring Global Investments, and you’re listening to On The Trading Desk®.  Today, we’re discussing the key things you need to focus on for pension plan investing in 2023. Thanks for being here, Andy.

Andy: Happy to be here.

Katie: I think it is fair to say corporate pension plans in the U.S. have been under some stress for the last 15 years or so since the Global Financial Crisis, but things are better now. Andy, what is your assessment of the state of play and what should be top of mind?

Andy: Yes, funded ratios are universally improved. The rising tide of increased discount rates, we’ve got long Treasuries now over 4% and that’s the highest for about 10 years. And strong equity returns have helped and the result is that funded ratios are now above 100% for most plans. And yes, we’ve been waiting for this for 15 years. I think it’s actually this month, 15 years ago, that things all started to unravel as the financial crisis had its impact. And so, my first key point is that strategic decisions should dominate. Tactical decisions and timing should fade. By this, I mean that if you said to yourself in the depths of the funding hole that you would hedge more liabilities and de-risk when your funded status increased and yields got back to, quote, normal, well, that is essentially now. So, the actions to take include firstly, move along your de-risking glide path; secondly, focus on improving the design of the elements within your plan, i.e. both the LDI (liability-drive investing) or liability-driven part and the excess return seeking part; and thirdly, employ best practices in terms of implementation. After all, the principles of good investing are always good and pension plans are no different.

Katie: Thanks. That makes sense. The best practices in pension plan investing are always evolving. To this end, could you talk about how that applies to LDI portfolio design?

Andy: Yeah, sure. The LDI design dimension starts with understanding liabilities in terms of their investable risk characteristics. In the U.S. for corporate pension plans, this is mainly rate duration and term structure and credit exposure and term structure. Inflation can be an element, but it’s much less important than, for instance, in the U.K. when inflation and liabilities are the norm. So, we find that it is useful to consider these two risk elements, rates and credit spreads, separately and address each of them through matching exposures with suitable assets. And as mentioned previously, there is a strategic and a tactical dimension to both. So, in effect you have four items to work on, Treasury and credit exposure and both strategy and tactics. This generally leads to a need for custom LDI benchmarks, but these can be quite straightforward in use, often using standard benchmark elements, although a full liability-based benchmark is also possible. So, I’ve already mentioned that strategy should dominate and most pension plans should adopt, therefore, a fairly full liability hedge, in our opinion. Certainly, the tactical impediment to extending duration has largely passed, in our view. But that is not to say that tactical views cannot or should not be entertained. One opportunity present at the moment is that of a curve steepener. And in this regard, I’m talking about the longer end of the Treasury curve, for instance, the 10/30 part of the curve. This is where pension liabilities exist in the majority, and hence, it’s a natural place to consider asset liability matching through your LDI portfolio. Most pension plans are naturally positioned for steeper yield curves, especially those that are not fully hedged. This is due to the fact that the long tail of liabilities loads heavily on the long key rates. Anyway, the Treasury yield curve is unusually flat and, in fact, I would say it’s historically flat. Hence, a steepener profile in terms of assets versus liabilities is a tactical view I like and can support. The point to note is that pension plans have had this profile on for the last several years, which will have been costly. Hence, while it can be supported presently, it should be something that is consciously reviewed and mitigated when the tactical picture changes. What this means for some pension plans, especially more mature ones that are well funded is that adding intermediate bonds to their initial long LDI portfolio makes sense. The point is that LDI design and custom benchmarks can and should evolve. I will note that these points and others were covered in a paper we wrote recently which was titled, Doing LDI Well in 2023 and Beyond.

Katie: Thanks, Andy. You’ve covered LDI design choices, but what about the implementation? What are people seeking and talking about in that regard?

Andy: So, the almost universal implementation conversation in LDI is to how to do the best job at adding diversified credit return over and above Treasuries. The ideal situation is to have a broad array of yield payers, i.e. diversified sources of yield, and to capture good alpha in a manner that is diversified across your managers and the opportunity set. As we’ve sort of all seen, convention has it that pension plans first went to long duration investment grade corporate bonds as their staple for LDI. And to many this is still about 70% of their LDI portfolio. But as more and more dollars flow into LDI, what improvements can be made? Well, there are various facets of the fixed income market that need and should be considered and perhaps reconsidered as the aging of liabilities means the intermediate part of the market is equally important these days. One of the things I note is that making a comeback, perhaps after all these years, is core and core plus mandates, i.e. more aggregate type mandates that can offer breadth and diversification and alpha opportunity. And within the strategic and tactical framework that I’ve outlined can be efficient in the context of a wider LDI portfolio. Another aspect that we talk about is improving portfolio and alpha diversification in long credit by observing and sidestepping the concentration and herding issues that we see present in the long credit market, strategies that play well in that part of the market, enabling alpha to be captured both from the large liquid part of the market but also importantly from the smaller and, in our mind, under-researched credits. We believe this is a powerful combination. A further point I’ll make is that as you move further out on this quest for credit diversification, you get to what I might call credit alternatives. These tend to offer more diversification from public investment grade corporate bonds but generally add complexity or illiquidity or perhaps both. But the benefits can be there and the skill in building these strategies together into a working LDI portfolio is to make sure that you are capturing the benefits while still retaining the appropriate degree of liability hedging. That is where the state of the art is.

Katie: Thanks, Andy. A lot to consider for sure, but topics that seem to be front of mind with all clients that I talk to. Moving on a little, what do you want to say on the topic of evolution and changes to the return-seeking element of pension portfolios?

Andy: Well, 2022 reminded us that there is risk in the equity risk premium. It was a tough year. Equities are good in the long run, but to be fair, many pension plans are not the longest of long-term investors anymore, especially when it comes to the time horizon they want to hold their return-seeking assets for. This has two implications. Firstly, liquidity needs to be guarded and maintained in the return-seeking part of their portfolio, so new private assets are not that welcome. And secondly, the path and pattern of return matters, meaning downdrafts can be awkward and unwelcome if you’re on a fairly short horizon to hopefully full funding. So, to this end, we’re seeing more interest in two types of return-seeking strategies. Firstly, equity downside risk mitigation strategies, such as protection overlays. These aim to preserve the basic characteristics of equities while trimming the left tails of downside events. This can be paid for by foregoing excess upside, which is of less use to many corporate plans, particularly if they’re mature and close to full funding. Or it can be paid for through in an outright sense, through a reduction in the expected return of the equities. Either way, well-engineered strategies proportionately reduce risk more than they cost, hence, enabling increased investment efficiency. And the upshot of that is that equities can be retained longer into glidepaths than unprotected equities can, which leads to expected return and asset benefits and improve, what I call, path dependency or improved resilience. The second area is a renewed interest in harnessing other forms of rewarded risk premia to complement the dominant risk in most portfolios, i.e. equity risk premium. This can be accessed through certain styles of hedge fund but also diversified and broad-based return premia harvesting strategies, so-called alternative risk premia strategies. The benefits of this approach can be seen in 2022, where ARP (alternative risk premia) strategies generated positive returns and in some cases double digit positive returns, while equities were down 20 to 25%. Again, the benefit is a smoother pattern of return, which helps the quest for steady funded ratio improvement.

Katie: Wow. You have provided a lot to think about. You said at the start that this is an exciting time for corporate pension plan investing and I think you have highlighted several items that make this point. Thank you, Andy, for being with us today and sharing your insights and knowledge.

Andy: As always, nice speaking with you, Katie.

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Originally Posted July 27, 2023 – LDI = Let’s Do It (Now Is the Time to Make Improvements to Your LDI Portfolio)

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