It is a challenging time for pension funds. In a low-return environment, many are tackling funding shortfalls, and are searching for new ways to generate alpha. In the past, schemes used conventional benchmarking to measure performance and risk. The fallibility of such an approach became obvious after the market downturn, when the growth in liabilities far exceeded returns on assets. Now, many funds have changed their perception of risk and risk budgeting, and are looking at ways to incorporate liability-driven investment solutions into their portfolios.
Liability-driven investing seeks to better manage a plan’s liability risk, while also offering diversified sources of return. LDI recognises that meeting or exceeding a scheme’s future cash payments is the true measure of investment success. It is better to deliver pension fund liabilities than outperform a peer group or benchmark. While solutions will vary according to a plan’s funding status, risk appetite and mandate constraints, LDI offers schemes a more efficient and transparent way of hedging risk and outperforming liabilities.
Adopting an LDI approach
At a very basic level, this approach looks at a plan’s expected future cash payouts and then constructs a portfolio to hedge them. Solutions will involve some combination of physical and/or synthetic fixed income allocations, as these will closely mimic the changes in liability streams.
Defining a plan’s liability profile and funding status is the starting point for a liability-driven solution. The actuary’s task in determining a plan’s expected liability stream, once kept in the background and considered to be more of an art than science, has now moved to the fore to become the target benchmark. Actuaries typically factor in unknown variables such as how long employees may work and live, as well as the future directions of interest rates and inflation. Maturing schemes that rushed to close to new members as deficits grew are now better positioned to predict what future payments are required, essentially creating a bond-like benchmark. While measuring and recognising the true nature of the liabilities is the first essential part of the solution, solving the problem of closing the deficit is the challenge as few funds and sponsors can simply afford to hold bonds.
Many funds are tackling serious funding problems, and are re-evaluating their approach to liabilities as a result. According to Watson Wyatt, the average funding ratio for US pension funds fell from 116% at the end of 1999 to just 75% at the end of 2002. Another recent study from actuarial consultants Lane Clark & Peacock shows that the combined European pension deficit stands at e116 billion, with Germany, Spain, and the UK netting the biggest pension deficits in Europe.
Across the continent, new regulations have been created to try and address the problem. In the UK, the Pension Protection Fund was established to protect defined benefit scheme members whose employers become insolvent. And this year, FRS 17 requires companies to account for pension assets and liabilities on their balance sheets. In the Netherlands, schemes have until next year to mark their assets and liabilities to market. In Sweden, asset and liability modelling is now obligatory for the country’s Allmänna Pensionsfonden (AP) funds, which back the governments’ pay-as-you-go scheme.
Lastly, throughout Europe the accounting standard IAS 19 is being put in place to create more transparency around a company’s pension plan costs, liabilities, and the assets backing them.
All this is turning trustees into risk managers who do much more than search for performance or time the capital markets. There is no longer a “one size fits all” solution and peer groups are becoming obsolete.
Depending on a plan’s profile and risk appetite, a liability-driven solution may recommend a hedging strategy consisting of appropriate fixed income investments. At one extreme, mature schemes might try to completely immunize against expected liabilities with a series of swaps or matching long-dated bonds. Apart from the scarcity of these types of bonds, this approach would be the most expensive while offering the highest certainty of paying pensions. Unfortunately, this is not an option for most plans, especially those that are severely underfunded.
A modular approach
With so many solutions being pushed in front of them, pension funds are faced with some tough choices. Some investment managers choose strategies that are purely alpha-driven, such as offering up combinations of hedge funds and traditional bond funds. Others remain within an asset allocation framework, with the hopes of capturing more market or beta risk. Another alternative is a truly flexible tailored approach that is modular in scope and allows different schemes to create unique liability-driven solutions with the appropriate constituent parts.
To better understand the modular approach, let’s use the traffic light analogy. Well-funded, low-risk solutions typically seek a 1%-2% return target above bonds. In this example, they would receive a green light solution because they may not need to take large equity risk positions and can afford to be more cautiously invested. These solutions are positioned to take full advantage of matching cash flow strategies and swapping undesirable risk back to the market.
However, once a fund is in surplus it can consider increasing risk as long as it never falls below the minimum solvency level. In such a situation, a dynamic risk allocation approach is more appropriate as risk increases with the level of funding and market opportunity. A manager is therefore able to determine how asset allocation should vary with changes in expected returns, funding levels and risk aversion over time in order to best meet a fund’s long-term return objectives.
Rather than managing three- to five-year investments against a static asset-related benchmark, such approaches create a liability-led matrix in which asset allocation is rebalanced on a quarterly basis depending on market changes reflecting the specific preference of the pension fund.
The yellow light applies to situations where there is a modest projected shortfall but where sponsors cannot tolerate a high-risk equity strategy, and seek a target return of 2%-3% above bonds or swaps. The risk budget for a yellow light can be a mix of portable diversified alpha such as global credit bonds, currency and equity strategies but will certainly not need to rely heavily on the long-term equity risk premium.
The red light goes to pension schemes that are markedly underfunded, have a weak sponsor, and are forced to adopt a high-risk, 4%-6% return strategy above bonds. Here, downside risk protection is a major problem and methods to protect the scheme will need to be reviewed as market opportunity changes. These solutions can range from the use of options to dynamic rebalancing as market environments change, but both alpha and beta have something to offer. Pragmatic combinations of alpha and beta coupled with possible top-up contributions from sponsors allow risk budgets to be more wisely spent.
As a result, investors should seek
an investment manager that can create a customized and appropriate modular solution that includes a range of liability-hedging and return-seeking options. When selecting a master manager, investors should consider their experience in designing and customizing solutions involving liability hedges, market exposure and alpha generation strategies, all of which require
oversight of the different portfolio
For example, partial-funded swap overlays can be used to hedge duration and inflation risk, but an underfunded pension scheme will need to take more active risk than a Libor cash return to fund the hedge. One option here might be to employ an active bond fund or other manager strategy. If so, not only must the collateral for the swaps be managed alongside the active strategy; the mismatch introduced from the active strategy itself must be hedged away to access the portable alpha. The role of master manager is therefore to monitor and adjust the moving parts rather like an asset allocation rebalancing strategy.
An easier, practical alternative would be to use a series of pooled swap funds. By buying a series of different maturity funds that can be tailored to passive interest rates and inflation hedges, investors can create cash flows to pay future pensions. This kind of modular approach suits pension funds that believe they can capture a modest market return without being exposed to equity volatility and the potential of large negative returns.
Modular solutions must also allow for the use of multiple alpha strategies aimed at maximising a portfolio’s risk-adjusted returns with diversified sources of alpha. Such solutions add value by actively managing the weighting of the constituent strategies according to market conditions.
For example, 10 or more diversified sources with low correlations may be combined to target a return in a partially funded structure delivering best-of-breed strategies in a single fund. The risk-return characteristics are superior when combined with a hedging portfolio, as risk is only taken to deliver the active return.
Alpha sources within a multi-strategy approach are frequently managed in a market-neutral fashion, with target volatilities slightly higher than the targeted return. Leverage is used within the individual alpha components to achieve the target. The market-neutral nature ensures that each strategy has an equal risk budget within the whole portfolio. Risk can then be defined as the portfolio’s volatility and is estimated using the actual and simulated returns of the constituent strategies. During portfolio construction, volatility rather than return becomes the target.
Using such an approach, strategies would be reviewed, rebalanced and re-allocated quarterly, with investment guidelines allowing for changes in the overall portfolio compensation, adding flexibility to the process. Given that alpha can be scarce, transitory and capacity constrained, such flexibility is important.
As pension trustees take on more of the role of risk manager, they need to be more creative about adopting a framework that will manage both assets and liabilities in step with market changes. Given the sad reality of looming pension shortfalls, the time to express that creativity is now.
The views expressed are the views of Joe Moody only through the period ended August 31, 2005 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information does not constitute investment advice. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.