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Pensions & Investments: LDI Proves its Worth in Era of Interest Rate Volatility

September 5, 2019

NEPC's Brad Smith was featured in a Pensions & Investments article on liability-driven investing portfolios. View the piece here.

Corporate pension executives who called interest rates right in adjusting their liability-driven investing portfolios to protect their plan's funded status now are tweaking their growth portfolios.

Pension plan chief investment officers are adding more risk assets, particularly private credit, for diversification and to increase overall fund returns.

Corporate defined benefit plans that two to three years ago prepared for an eventual decline in interest rates by increasing the proportion of assets managed in their LDI portfolios to hedge interest rate risk and decreasing riskier assets in their growth portfolios weathered recent interest rate declines well, said industry sources.

Among the funds that were prepared was the $30.4 billion defined benefit plan of United Technologies Corp., Farmington, Conn.

"This is how LDI is designed to work, to protect the funded status of the pension fund from interest rate risk," said Joseph M. Fazzino, senior director, pension investments.

About 54% of total plan assets were managed in UTC's LDI portfolio primarily in long-duration bonds, with a small allocation to private credit as of July 31. UTC's LDI portfolio hedged 66% of the entire fund, Mr. Fazzino said.

Among plan sponsors that employ an LDI strategy, the degree of protection against interest rate declines was critical this year.

"In this environment of falling interest rates, it really mattered whether you hedged enough of the risk and limited your exposure," said Jay Love, an Atlanta-based partner and investment consulting leader for Mercer Investments' U.S. wealth management unit.

He said some defined benefit plan staff hedged interest rate risk for 80% of their portfolios while most plans hedged the risk for 60% of total plan assets and others covered 40% or less.

Mr. Love said the problem for plan sponsors now is that if they didn't hedge enough of their portfolios against interest rate moves, it's probably too late given where rates are now.

"The horse is out of the barn for interest rate hedging and you really can't go back and fix it now," Mr. Love said.

Higher pension liabilities

Interest rate volatility has risen sharply this year, raising corporate pension plans' liabilities.

High-grade corporate bond interest rates — as measured by the Bloomberg Barclays U.S. Corporate Long AA index — fell to 2.88% by the index's yield-to-worst measure for the year through Aug. 28, down from 4.17% as of Dec. 31.

"Corporate pension funds are very sensitive to real-life interest rate volatility and want to invest in a way which reduces that volatility to protect their funded status," said Timothy L. Boomer, head of client solutions for Boston-based Sun Life Capital Management (U.S.).

Sun Life Capital managed a total of $168 billion as of June 30, including $106 billion in the general account of its insurance parent company, Sun Life Financial Inc., that is managed with a liability-aware strategy, and $9.9 billion managed in LDI strategies for corporate pension funds.

Many U.S. corporations significantly increased contributions to plans between 2016 and 2018, when interest rates were as much as 100 basis points higher than today, to avoid high premiums charged by the Pension Benefit Guaranty Corp. and in advance of new tax laws.

Corporate pension fund investment teams acted then to protect their plans' funded status by moving out of equities and putting those assets into LDI hedging portfolios, a strategy that has paid off, Mr. Boomer said.

"Companies which sufficiently hedged (interest rate risk) in their pension portfolios through their LDI portfolios are doing very well now," Mr. Boomer said.

There isn't a standard index for LDI returns, but investment consultants said a good proxy for the long-duration bonds many pension funds hold in the portfolios is the Bloomberg Barclays Long AA-rated Corporate index, which returned 15.1% for the year ended June 30 and 13.8% in the six months ended June 30.

Investment officers of U.S. corporate defined benefit plans that did not hedge interest rate risk enough through an LDI approach are "in a world of pain now," said Kam-Hon Chang, principal and head of client advisory with SECOR Asset Management LP, New York. SECOR managed a total of $40.3 billion as of June 30, of which $13.6 billion was in LDI strategies.

"Interest rate and inflation risk are uncompensated risks and we advise investors to fully match liabilities and interest rates to mitigate risk," Mr. Chang said.

Growth portfolios key

For plans still a long way from the end of their full-funding glidepath, when 100% or more of the portfolio likely is managed using an LDI strategy, growth portfolios are important to pump up returns, cash flow and portfolio diversity.

"The goal of a plan's growth bucket is to outperform liabilities over the long term and to provide a little jump to cover unexpected events such as changes in mortality rates," said Sun Life Capital's Mr. Boomer.

Among the strategies many corporate plan executives are adding to their growth portfolios are private credit, including direct lending; bank loans; structured products; private equity; real estate debt; high-yield municipal bonds; and hedge funds, sources said.

In fact, because LDI has become "a mature holding in a corporate defined benefit plan portfolio that's managed in a straightforward way, many investors are spending a lot more time on managing the growth portfolio," said Bradley S. Smith, a partner at investment consultant NEPC LLC, Boston.

This year, returns of a fund's growth portfolio also will help to maintain funded status.

Mercer's Mr. Love noted that "liabilities increased a lot" for corporate plans because they have a direct correlation with interest rates, and added that asset growth in both LDI and growth portfolios in the first half of this year helped to offset those increases.

In United Technologies' case, the combination of asset gains from the 14.6% return of the defined benefit plan's LDI portfolio year-to-date July 31 and the 13% return of the growth portfolio were enough to offset the $2.5 billion rise in plan liabilities in that period. As a result, the plan's funded status remained at 98%, the same as of Dec. 31, Mr. Fazzino said.

Consultants and LDI managers said some corporate fund investment teams are now including diversifying assets in the LDI hedging portfolio, not the growth portfolio.

Among the early adopters is United Technologies.

The fund's LDI portfolio is primarily invested in intermediate and long-duration investment-grade bonds as well as futures, swaps and Treasury STRIPS.

Mr. Fazzino and his partner in managing the LDI portfolio, Thomas Borghard, associate director, pension investments, have added alternative credit strategies to the liability-hedging portfolio.

By adding alternative credit investments, including commercial and residential mortgage-backed securities, collateralized loan obligations and real estate debt, Messrs. Fazzino and Borghard are diversifying the credit spread risk from the portfolio's investment-grade corporate bonds.

"It's a small allocation, but what we're looking for is incremental diversification," Mr. Fazzino said.

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