- When it comes to addressing the unprecedented challenges faced by retirement plans today, we believe a one-size-fits-all approach just isn’t enough.
- In this paper, we’ve worked with a leading business school to develop a model representative retirement plan and, using the latest simulation and modeling building technology, we aim to show the clear benefits of adopting LDI as a way of improving retirement outcomes.
- We believe the simulation results show that by incorporating key-rate duration matching, introducing Plus assets, and introducing a dynamic derisking strategy, we can not only reduce the volatility of a plan’s funding position over time, but also improve the plan’s likelihood of being able to achieve a well-funded status.
Since the global financial crisis, retirement plans have increasingly adopted an LDI approach to managing risk. Pursuing the goal of making all payments due to plan members in full and on time requires as robust an investment strategy as possible.
So what makes LDI so special?
Liability-driven investing (LDI) is a holistic investment strategy applied not only to the plan’s assets, but also to its liabilities. It recognizes that if the goal of a retirement plan is to make all benefit payments in full and on time, then the success of any investment strategy should be judged against this goal and this goal alone. This in turn leads to a simple conclusion: The benchmark for a retirement plan should be based on its own liabilities rather than on a financial market index or on any combination of such indexes. This approach means that all investment decisions and, more important, all related risk management decisions, should be undertaken with an eye firmly on the plan’s liability profile instead of market indexes. Designing an investment strategy that pays little or no attention to the shape and nature of plan liabilities would be a bit like a cobbler fashioning a very elaborate pair of shoes for a client without measuring the client's feet first.
Seen through this lens, the plan’s liabilities represent a negative asset. This negative asset has similar risk characteristics to a bond portfolio, since the liabilities comprise fixed payments (some linked to inflation) stretching out into the future. They can therefore be valued as we value a fixed-income portfolio comprising bonds issued by governments and corporations. It also means that the value of these liabilities will have the same inherent economic risks as a portfolio of bonds: The value of the liabilities will fall as interest rates rise and rise when interest rates fall. They’ll also rise with higher-than-anticipated inflation and fall with lower realized inflation.
These risks are often characterized as being unrewarded. If we assume that both interest rates and inflation rates tend to mean revert over time, then the financial position of the plan will be affected by the volatility of interest rates and inflation, but there will be no long-term gain for bearing these risks. This is in contrast to the risks associated with other investments, such as equities. Although equity prices rise and fall over time, we assume that there’s a positive, long-term risk premium that can be earned from holding equities that rewards investors for bearing this risk.
If interest-rate and inflation risks are unrewarded, why bear them?
An LDI investment strategy usually comprises two key elements. The first is to hedge, as far as possible, or as far as affordable, the unrewarded risks posed by the plan’s liabilities. This can be achieved with the construction of a bond portfolio and with the addition of derivatives such as swaps that have similar risk characteristics to the liabilities. When hedged perfectly (which isn’t always possible), any rise in the value of the liabilities will be matched by an offsetting rise in the fixed-income portfolio. In this way, the plan can get closer to the panacea of risk management.
But in the event that a plan is in deficit—that is, where the value of the assets is lower than the value of the liabilities—constructing a fixed-income portfolio that matches changes in the value of the liabilities may not, on its own, be sufficient to close this deficit. This is where the construction of an appropriate portfolio of return-seeking assets comes in as the second key element of an LDI strategy. Return-seeking assets are expected to grow in value over time, closing the gap between the value of the assets and liabilities and thereby ensuring that there are sufficient funds to meet all retirement obligations.
An alternative approach to LDI
The traditional growth asset class is publicly traded equities; however, this asset class can fall in value dramatically. Furthermore, there’s generally a negative correlation between equities and treasuries in times of crisis, so liabilities may rise just as equities are crashing, thereby compounding the problem.
This is why some retirement plans have addressed this issue in two complementary ways that are consistent with the philosophy of LDI. First, plans can diversify their growth portfolio across a wider range of asset classes. Second, plans can invest in return-seeking assets such as infrastructure, commercial property, timber, and agriculture, which typically produce a reward over the long term. These assets classes, which are typically referred to in the asset management industry as private, real, or alternative assets, are what we call Plus assets for LDI portfolios, as we believe they can offer additional benefits from a liability-matching perspective, increase the diversification of a multi-asset portfolio, and can also provide a liquidity premium. We therefore believe that having Plus assets within a portfolio can help to close a deficit over time and, additionally, help to reduce the volatility of the plan’s liabilities. Focusing both the fixed-income portfolio and the growth portfolio on plan liabilities—with these same liabilities acting as the benchmark for these assets—is the essence of LDI.
Putting our theory to the test
To help demonstrate the benefits of a multicomponent LDI approach to retirement plan management and to test the extent to which LDI can help improve the likelihood of meeting all retirement obligations in full and on time, we commissioned Professor Andrew Clare of Bayes Business School1 to construct a model based on the latest academic research. The results of the model form the basis of this paper.2
Their research found that:
- A key rate duration (KRD) matching strategy produces better results in terms of risk management than those that can be achieved by investing in a traditional bond portfolio.
- An investment strategy that relies too heavily on the performance of equity markets, all else equal, will have a high probability of failing.
- Including Plus assets in the growth portfolio probably requires a more dynamic approach than can be achieved through straightforward annual rebalancing.
- A dynamic approach to asset allocation that combines a KRD-matching strategy and an allocation to Plus assets can improve the prospects of achieving a wide range of funding objectives.
The representative plan
To demonstrate how an LDI approach to the management of retirement plan assets can help reduce the risks that a typical plan faces, we’ve designed a representative retirement plan. We’ll use this plan in the simulation experiments so that we can gauge the impact of different strategies on the financial health of the plan.3
Our plan faces the set of liability payments shown in Figure 1.
Figure 1: the liability profile of the representative plan
Source: Bayes Business School, Manulife Investment Management, 2021. For illustrative purposes only.
The liabilities faced by our plan peak around 20 years’ time, and the last cash flow occurs in 80 years’ time. The cash flow in the first year is $16.25 million, which represents 2.71% of the total liability.4 While the benefits of LDI can be achieved regardless of a plan’s circumstances, we’ve set the duration of the liabilities for our plan to just over 17 years.5 This means that a one percentage point fall in the liability discount rate would cause the value of the liabilities to rise by approximately 17 percentage points. The present value of these liabilities at the start of the simulations is always $600 million. This present value has been calculated using FTSE Pension Discount Curve data.6 Finally, for simplicity, we assume that the plan is closed to both new entrants and future accrual.
We can use the liability profile shown in Figure 1 to demonstrate different approaches to hedging the risks inherent in the liabilities. To do this, we assume that a bond portfolio has been constructed that has the same value (present value) as the liabilities at the outset of the 10-year simulation period. Using Monte Carlo techniques, we then simulate 10,000 paths for the bond assets and the liabilities over the course of this period.2
To establish the advantages and disadvantages of different approaches to hedging plan liabilities, we investigate the performance of three bond portfolios, where the liabilities are always discounted using the FTSE Pension Discount Curve. In addition, to keep the analysis simple, in these simulations we assume that the value of the bond assets, whatever their composition, matches the value of the liabilities at the start of the 10-year simulation period.
The bond portfolios are represented by:
- Market index—The Bloomberg Barclays U.S. Aggregate Bond Index (Agg)
- KRD matching with credit allocation—A 50% investment in a portfolio of treasuries and a 50% investment in the bonds comprising the FTSE Pension Discount Curve (KDM-50/50)
- KRD without credit matching—The portfolio comprises a 100% investment in the portfolio of bonds that makes up the FTSE Pension Discount Curve (KDM-100)
As we progress through the strategies listed above, we gradually increase the precision of the matching strategy. But what impact does it have on the plan’s funding position in 10 years’ time? To answer this question, we simulate the paths of the liabilities and assets described above 10,000 times in each case. This allows us to look at the consequences of each hedging strategy. To run the simulation exercises for each of the strategies, we used monthly data on all the key financial variables spanning the period from 2008 to 2019.7
Figure 2: liability hedging
Figure 2 presents some results that summarise the simulations.2 The bars represent the 5th percentile of the funding ratio distribution, where 95% of the funding ratio outcomes after 10 years were greater than this value. As expected, the figures show that the worst-performing strategy is the Agg: The 5th percentile value for this strategy was found to be 66%, which means that 5% of all outcomes were worse than this value. With regard to the KDM-50/50 and KDM-100 strategies, we can see that the distribution of outcomes is now very narrow; for example, with KDM-100, the 5th percentile is found to be 97.6%.
In summary, these results demonstrate that the KRD strategies produce better results in terms of risk management than those that can be achieved investing in a traditional bond portfolio.
The growth portfolio
Having demonstrated how different approaches to liability hedging strategies perform, we now turn our attention to the growth portfolio. The main purpose of the growth portfolio is to generate the returns needed to make up for the deficit when the plan is underfunded. In this next set of experiments, we therefore assume that the representative retirement plan begins the 10-year simulation period with a funding ratio equal to 85%. Again, using data spanning the period 2008 to 2019, we investigate the performance of a combination of equities and bond portfolios. We also introduce the plan sponsor into these simulations. One of the most important assets of any retirement plan is the financial support of the sponsor. We therefore assume that the sponsor pays a fixed sum of $12 million into the plan for the first 7 years of the simulation period. This contribution is equivalent to 13% of the deficit of the plan at the start of the simulations.
We combine the liabilities shown in Figure 1 with three alternative bond portfolios, but where the allocation to equities is always 60%. We also assume that the plan rebalances its asset portfolio back to a 60%/40% equity/bond at the end of each year in the simulation. The three alternative bond portfolios are represented by:
- An allocation of 40% to a portfolio of bonds—Represented by the Agg (40% Agg)
- An allocation of 20% to a portfolio of bonds—Represented by the Bloomberg Barclays U.S. Treasury index and an allocation of 20% to a portfolio represented by the bonds in the FTSE Pension Discount Curve (40% DM). This bond portfolio has been constructed to match the duration of the liabilities
- An allocation of 20% to a portfolio of bonds—Represented by the Bloomberg Barclays U.S. Treasury index and an allocation of 20% to a portfolio represented by the bonds in the FTSE Pension Discount Curve (40% KRD Match). This bond portfolio has been constructed to match the duration of the liabilities at 5-year intervals; that is, it’s a KRD-matching portfolio.
The results of these simulations are shown in Panels A and B of Figure 3. In Panel A, we again present the 5th percentile of the distribution of funding ratios after 10 years. In sharp contrast to the results presented in Figure 2, where we started with a funding ratio of 100%, we see that the funding ratio 5th percentiles of each strategy are now around 50% for all three strategies. This means that on more than 5% of our simulations, the funding ratio was as low as 50% or less. These results indicate that, although the hedging strategies—both duration matching and KRD—result in better funding ratio outcomes than would be achieved by investing in a conventional bond portfolio, represented here by the Agg, the volatility of equities dominates the benefits achieved from the hedging strategies.
As an additional way of looking at the results, Panel B presents the proportion of times that the representative plan’s funding ratio exceeds 110% in the investment period. In practice, a plan that reaches, for example, 110% funding after 4 years is unlikely to continue taking investment risk for the remaining 6 years. The chart shows that from year 5 onward, the matching strategies reach this threshold more often than is achieved with the traditional bond portfolio. However, the exposure to equities still makes the prospect of achieving this level of funding (or greater) relatively low, with all three strategies having less than a 40% chance of achieving this level of funding after 10 years.
Figure 3: the growth portfolio, equities, and bonds
Panel A: funding ratio 5th percentiles
Panel B: % funding ratio > 110% after 10 years
In summary, an investment strategy that relies too heavily on the performance of equity markets, other things equal, will likely experience higher funding volatility.
Introducing Plus assets
So far, the results have demonstrated that a KRD approach to hedging liabilities produced excellent results in terms of risk management and that a reliance on equities to close this gap, even combined with a hedging strategy and with support from the plan sponsor, could still leave the plan underfunded after 10 years. Next, we’ll introduce Plus assets to the portfolio.
By diversifying across a range of asset classes, any shock to one of the components, such as the equity holding, might have less of an impact if other return-seeking asset classes are imperfectly correlated with the performance of the equity market. This is the benefit of diversification. Achieving this diversification by investing in alternative and real asset classes such as infrastructure, commercial property, timber, and agriculture—which we refer to as Plus assets for LDI portfolios—has the added benefit of bringing the risk characteristics of the growth portfolio more in line with the risk characteristics of the liabilities. By investing in Plus assets, retirement plans are essentially killing two birds with one stone. On the one hand, they’re building a more robust growth portfolio, and on the other, they’re staying true to the LDI philosophy of aligning the risks inherent on the asset side of their balance sheet with those on the liability side.
To investigate the value of integrating Plus assets into the growth portfolio, the plan can also allocate its funds to the following real assets represented by the related total return financial market indexes:
- U.S. real estate—The FTSE EPRA Nareit US Real Estate Index
- Global infrastructure—FTSE Global Core Infrastructure Index
- Global timber—S&P Global Timber and Forestry Index
- Global agriculture—NASDAQ OMX Global Agriculture Index
One of the drawbacks of these asset classes is that they’re generally less liquid than those that are traded on public exchanges, but this is only really a drawback for those investors who require their investments to be very liquid. For investors such as retirement plans, with very long-dated financial commitments, this illiquidity represents less of a drawback and more of an opportunity. This is because investors in these asset classes can expect to earn a liquidity premium; that is, an addition to return in compensation for assuming this illiquidity.
However, it’s important to acknowledge in the modeling that higher transaction costs might be incurred when investing in or disinvesting from an illiquid Plus asset class compared with investment in and disinvestment from, say, publicly traded equities.2 To deal with this real-world problem, we impose a transactions cost of 7.5%, which applies with any redemption of a holding in a Plus asset class. So, for example, if the investment is valued at $100 million, selling this amount of the asset class would only realise a value for the plan of $92.5 million.
To investigate the role that Plus assets can play in closing the funding gap, the representative plan again begins the 10-year simulation period with a funding ratio of 85%, but the plan’s portfolio is represented by:
- An allocation of 40% to a portfolio of equities, represented by the S&P 500 Index
- An allocation of 40% invested equally between a portfolio of treasuries and the bonds comprising the FTSE Pension Discount Curve, where the bond portfolio has been constructed to match the duration of the liabilities at 5-year intervals; that is, it’s a KRD-matching portfolio
- An allocation of 20% invested in four Plus asset classes: real estate, infrastructure, timber, and agriculture (5% invested in each one)
Figure 4: adding plus assets
Panel A: funding ratio 5th percentiles
Panel B: % funding ratio > 110% after 10 years
In Panels A and B of Figure 4, we’ve presented the results of the simulation. In Panel A, we see that the 5th percentile for the strategy that incorporates Plus assets is lower than the comparable simulation without Plus assets. The main reason why the Plus assets haven’t improved the final outcome for the representative plan is due to the rebalancing that occurs in the simulation at the end of each year, which, with the assumed higher transaction costs, has a detrimental effect on the performance of the growth portfolio.
Panel B of Figure 4 shows the probabilities of reaching a 110% funding ratio over the 10-year planning horizon. We see that the probability is lower at all points over the period with the inclusion of the Plus assets. This leads us