By all accounts, 2008 was a grim year for all institutional investors. But it may have been even grimmer for pensions plans – most of whom were caught in the squeeze between falling asset values and rising liabilities. As markets cut the knees out from under already weakened defined benefit (DB) plans, low interest rates added insult to injury by increasing the present value of their future pension payouts.
A recent report (free reg. req’d.) by Russell Investments called “What’s Next for LDI?” suggests that many beaten-up pension boards will finally take liability driven investing to heart in 2009.
Why? Because for many companies, pension liabilities have now become so large that they now swamp the total market cap of some companies. For example, Russell compares the pension liabilities of oil companies and airlines to prove the point. Both types of companies have similar size pensions, but since airlines have smaller market caps, their “projected benefit obligation” is 150% of their market cap (vs. only 6% for the much larger oil companies.) Astoundingly, the unfunded portion of airline pension plans alone is 40% of the market cap of the airlines themselves.
The report is pretty meaty but easy to comprehend and is worth a read for both LDI neophytes and LDI-ophiles.
Russell recaps what it calls “The four stages of LDI”:
- Stage 1- “Lengthen”: Liability streams are like bonds. But those bonds tend to have a much longer duration than the assets set aside to purchase them back in the future. So according to Russell, the first line of attack for any LDI program is to simply invest the fixed income portion of the assets in longer duration bonds.
- Stage 2 – “Reallocate”: The problem is that most bonds still can’t match the mammoth durations of the typical pension liability stream. On top of that, only a portion of most pension funds are allocated to fixed income anyway. So the next line of attack, according to Russell, is to reallocate assets from equities to fixed income.
- Stage 3 – “Overlay”: Often, lengthening and reallocating still leave the duration of assets far below that of the pension’s liabilities. So the next strategy is to buy raw interest rate exposure synthetically in the form of derivatives. Besides goosing the duration of the asset portfolio, overlays (such as swaps) can also “fine tune sensitivity to each part of the yield curve” according to the firm.
- Stage 4 – “Immunize”: With most of the interest rate risk in the liability stream offset by an asset portfolio with a matching duration, Russell says that now is the time to “take steps to manage the effect of other factors that affect pension liabilities.”
And that is precisely where Russell sees LDI going in 2009…to Stage 4, “Immunization”. Says the firm:
“The credit crisis of 2007-2008 and equity market volatility will lead to increased focus on LDI and to programs looking beyond interest rate risk and other risks such as credit risk, curve risk and timing.”
While the duration of assets and liabilities can be made to match, there is always a risk that the chosen assets might react to other non-rate influences such as credit risk. Curve risk, on the other hand, refers to the fact that “in practice, changes in interest rates affect different parts of the yield curve differently” according to the report.
While credit risk and curve risk can be managed, the question of timing (i.e., when to lock-in to an LDI program) remains a sticky question. Russell says that “timing had become more favorable for plans looking to move into long corporate bonds as part of an LDI strategy.” But on the other hand, the firm points out that this may not be the best time to sell (beaten-down) equities to fund those purchases.
Despite these lingering questions, Russell says that LDI is reaching a “tipping point” precipitated by changing accounting rules and changing attitudes.
One of those changing attitudes will be reflected by the transfer of pension risk to third parties through “annuitizations” and pension buyouts. While such sales of entire pension plans have been popular in the UK (see related post), Russell notes that they remain in a legal limbo in the US.
Defined benefit pension plans have been pronounced dead several times over the past few years. But Russell, for one, believes LDI will breath new life into these funds, proclaiming confidently:
“The story of DB is far from over.”
So worried pensioners take heart next time someone tells you that your dreams of retirement are all in your head.