The results from a survey were released last week on a topic that will either interest you or bore you tears: Liability-Driven Investing (LDI). We’ve covered this topic here at AllAboutAlpha.com because one of its constituent parts is often a hedge fund or portable alpha strategy.
More on the survey below. But first, if you do all you can to avoid this topic; you might be well served to give it a second chance. Try looking at it this way…
Pension Liabilities: Del Boca Vista
Frank Costanza: Are you telling me there’s not one condo available in all of Del Boca Vista?
Morty: That’s right. They went like hotcakes.
Frank: How’d you get yours?
Morty: Got lucky.
Frank: Are you trying to keep us out of Del Boca Vista?!
Let’s say you’re Seinfeld’s Frank Costanza (George’s father) and you’re saving for a glorious retirement at Del Boca Vista, a well-manicured retirement community in sunny Florida. It’s 1998 and you calculate that your annual savings plus a few good hedge fund investments will cover the costs of that dream condo (to be built some time in 2011).
Each year you meet with your financial planner who tells you that you’re on track for your dreams. But somewhere around 2002, she tells you that despite a killer year for your hedge fund holdings, you’re coming up short on your goal of buying that condo. Apparently the South Florida real estate market is going crazy.
You have a choice, either sell the 30 foot long white Cadillac you just bought or somehow move your existing savings into something that will also rise with South Florida real estate â€“ perhaps a real estate mutual fund or the stock of a South Florida home builder. You do the later and things seem to get back on track.
By 2006, you’ve actually made a good chunk of change on your home builder stock. But alas, the average price at Del Boca Vista has appreciated just as much, if not more.
Then comes 2008. Your stock tanks and you start to consider moving in with your ne’er-do-well son in New York. But before you do, you check in with the financial planner. Good news! Del Boca Vista condos are being foreclosed left, right and center. It turns out that your retirement plans are just as on-track now as they were back in the halcyon days of 2002.
Your financial planner basically matched your assets (savings and future income) with your liabilities (the future cost of that condo). To achieve a perfect match, she might have bought some kind of derivative contract based on Southern Florida real estate, or she might have even suggested you just buy an existing condo in the development. You considered buying an existing condo, but you’d have to sell your hedge funds to pay for it â€“ thus losing out on any hope of extra returns for that granite counter-top in the kitchen. So you bought the home builder stock on margin.
Defined benefit (DB) pension funds face the same kind of issue when planning for the retirements of their members. The value of the future cash flows owed to plan members also fluctuates (due mainly to changes in interest rates, not housing prices). This can leave the pension plan in a lurch. Even with excellent investment returns, a pension plan can still fall behind if its liabilities go up by even more.
Like Frank, pension funds can tackle the problem by buying derivatives contracts that will inoculate them against changes in their liabilities (interest rate derivatives in this case, not real estate derivatives). Or like Frank, they can simply lock-in by buying an asset that is a perfect match against their liabilities (buying a long bond in this case, not a neighboring condo).
Also like Frank, the pension fund may not want to give up any upside that might be generated by smart investing. So they use derivatives to match off the future liabilities leaving cash free to continue investing in hedge funds (the so-called portable alpha part).
The bottom line is that when retirement hits, all you want is that condo â€“ whether it costs $100,000 or $800,000. The dollar values of gains or losses along way are irrelevant.
As we said above, Pensions & Investments recently released the results from an LDI survey it conducted along with Putnam Investments. The survey found that a fifth of defined benefit pension funds are currently using LDI while another fifth are considering it.
About half of those using LDI strategies were matching assets and liabilities (think Frank Costanza deciding to buy an existing condo in the above example) while another third were leaving assets free to pursue incremental (alpha) returns at the same time. Of those pensions that were trying to match-off assets and liabilities, about half used derivatives (think Frank Costanza buying a South Florida real estate mutual fund to ensure he’d have enough for the future condo).
When asked whether proposed US accounting changes (that would force companies to expense any extra required top-ups) would affect their decision to use LDI, the jury was essentially split.
While 70% agreed there would be no turning back now that LDI had been adopted at their pension plan, many respondents still remained hesitant to dive in right now. One of the main reasons: low interest rates (which increase the value of future liabilities â€“ click on chart at right). Why lock-in now, right as future liabilities are at their peak? Like Frank Costanza, why not see if those future costs might go down a little bit before locking in?