LDI: Our approach to the design, construction, and management of liability-hedging portfolios for U.S. DB plans

What kind of an impact do changes in rates have on a pension plan’s liabilities? An average U.S. DB plan has a liability duration of around 12 years. Oversimplifying a bit, this means that for every 1% fall in rates, the liability increases by 12%. In 2022, when rates rose by about 250bps, liabilities of this duration would have decreased by about 30%. A similar decline in rates would have a corresponding impact on the liability in the opposite direction. Considering the propensity for rates to change — sometimes dramatically — over time, it does make intuitive sense that this component would encapsulate most of the risk.

Interest rate risk can be effectively hedged through physical fixed income assets, which reduce risk but have limited potential to add returns above interest growth on the liability. While hedging interest rate risk may be a priority for the sponsor, they must also balance competing priorities such as generating additional return to become fully funded, or to cover ongoing benefit accruals. For plans managing these objectives simultaneously, the portfolio will need an allocation to return-seeking assets like equities.

Sponsors with a limited allocation to physical fixed income that are trying to hedge as much of the interest rate risk as possible ought to seek out the most capital efficient means of gaining rate/duration exposure in their portfolio, or in other words, get the most “bang for their LDI buck.” By extending the duration of the fixed income, the sponsor’s ability to hedge is enhanced. For this reason, we often use STRIPS (a zero-coupon version of Treasury bonds) to target exposure to the longest-duration government bonds. Longer-duration credit fixed income is also effective and has spread exposure, which holds both additional return potential and credit spread hedging.

2. Credit spread changes

The next important liability risk factor is credit spread changes. More specifically, the risk to plan sponsors that U.S. investment grade corporate bond spreads tighten, leading to lower discount rates, higher liabilities and lower funded status for a plan that is less than 100% hedged to changes in spreads.

Like interest rate risk, spread risk can be hedged with certain types of fixed income investments, and importantly, is correlated with a wide variety of asset classes. While in theory the most precise match to this liability risk is U.S. investment grade corporate fixed income (since this is a similar basis to the associated liability yield curve), the hedge will not be exact, mainly because the yield curve used for setting discount rates for liability calculations is not subject to “credit migration” that impacts the assets in the portfolio.

That is, the yield curve will only use bonds with a certain credit rating in their universe, while fixed income assets run the risk of loss from credit downgrades or defaults. To avoid funded status deterioration driven by this dynamic, this asset/liability mismatch must be made up for through other return sources, such as active credit management (to lessen the impact of credit migration) and return-seeking assets that will tend to generate higher returns than liabilities over time. Sponsors can also consider an allocation to LDI assets that are less subject to widening credit spreads than public fixed income (like credit diversifiers described later).

Other asset classes are correlated to credit spread exposure and should be considered in designing an LDI portfolio. Equities in particular — which tend to make up a substantial part of portfolios for underfunded pension plans — are correlated with spreads. Public fixed income credit spreads tend to tighten when equities are performing well (since the risk of default is lower) while spreads tend to widen when equities do poorly.

From a total portfolio perspective, the inclusion of equities can reduce the overall asset/liability (“funded status”) risk by adding equity return when spreads tighten (increasing the liabilities), but this may also lead to over-hedging spread exposure. In fact, some plans may find themselves far under-hedged on interest rates while far over-hedged on spread exposure. As the allocation to fixed income increases in the portfolio, these factors can be hedged with more precision.

3. Yield curve shifts

The last major factor to consider in designing a liability hedging portfolio is the impact of changes in the shape of the yield curve. While the overall dollar duration of rate and spread risk can be hedged, they implicitly assume that shifts in the yield curve occur equally across the curve (“parallel shifts”). But what if the yield curve steepens (when the gap between short and longer-dated yields widens), or flattens? Focusing the liability hedging on one point of the curve could lead to over-hedging those rates and leave other portions of the curve underexposed. Even if the hedge ratio is 100%, there is risk of non-parallel yield curve shifts misaligning the assets and liabilities.

Constructing an LDI portfolio

As mentioned, market-related liability risk factors can be hedged in a variety of ways. Most public asset classes have some correlation to liability-related factors. The focus of a skilled LDI adviser or manager is to understand and analyze the individual plan’s risk exposures in the existing portfolio and design an asset allocation that synthesizes all associated risks to reduce overall surplus volatility within existing return needs.

We group LDI building blocks into four broad components that could have a place in the LDI portfolio for different reasons:

1. U.S. Government Bonds
2. Investment Grade (IG) Public Credit
3. Interest Rate Derivatives
4. Credit Diversifiers

For more information on the potential benefits of each, please view the complete whitepaper.

Managing an LDI portfolio

The management phase of an LDI program involves the ongoing monitoring of asset and liability risk and dynamic portfolio repositioning. We believe sponsors should consider partnering with an investment solutions provider that has full visibility into their clients’ assets and liabilities, allowing them to monitor funded status, interest rate and credit hedge, and yield curve positioning daily.

The bottom line

The LDI process is a powerful tool for managing corporate defined benefit plans. By carefully designing, constructing, and actively managing the portfolio, plan sponsors can navigate the complexities of pension liabilities while aiming for long-term funded status stability and risk reduction.