Besides the fact that Liability-Driven Investing ("LDI") takes multiple forms (each of which should be fully evaluated in a risk-return context), there is no universal consent about relevant action steps. As described in "Why LDI is Stuck in Neutral" by Dr. Susan Mangiero, a "roll your shirtsleeves up" approach to gathering and assimilating information makes sense.
The full text of the June 12, 2008 MoneyVoices column, published by Fundfire.com/Money-Media, a Financial Times Company, is presented below, with permission.
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Why LDI is Stuck in Neutral
Guest Columnist: Susan Mangiero is president and CEO of Pension Governance, an independent research and analysis company.
Despite the hoopla, pension fund fiduciaries have yet to recognize liability-driven investing (“LDI”) as the ultimate in asset-liability management. No doubt a disappointment to the banking set, there are some legitimate reasons for its slow adoption. For starters, there is no consensus on what the term truly means, tempting one to use “loosely defined investing” as a more apt moniker.
Questions abound. When are derivatives used in lieu of cash assets only? Is a portable alpha engine an integral part of an LDI focus, or is it optional? Can LDI results be meaningfully benchmarked across plans? How does the use of LDI impact the determination of an optimal asset allocation mix? What must fiduciaries consider when assessing whether LDI-related fees are “reasonable?”
Even if everyone agrees on what LDI means, there is never a free lunch. What a plan gains in terms of risk mitigation, it will lose by assuming incremental risk. For example, using an interest rate swap introduces new uncertainties tied to counterparty default, settlement, legal standing and/or operations. A retirement plan that shifts money out of equity into typically lower yielding fixed income securities confronts opportunity cost. Add-ons in the form of alternative investments potentially juice up returns, but could wreak havoc with an existing risk budget. LDI makes sense when expected benefits exceed likely costs (direct and indirect).
Fiduciary literacy is yet another factor. Just as folks begin to ease into “new fangled” offerings, LDI forces decision-makers to take a sophisticated look at the economic funding gap. Understanding the dynamic behavior of asset and liability risk drivers is tough enough. Add a derivative instrument or hedge fund overlay and some decision-makers may dismiss LDI as complex and therefore “too risky.” More education is needed.
Deciding on the appropriateness of liability-driven investing is like anything else. Context and good process count for a lot. In some circumstances, an LDI strategy (however defined) may be a no-brainer. In other situations, its adoption could exacerbate existing problems. Regardless of outcome (“to LDI or not”), pension fiduciaries cannot escape their duty to ask questions, examine its likely risk-return impact (now and under various market scenarios) and oversee external managers’ risk controls (either as counterparties or potential alpha generators).
Disclaimer: The information provided by this article should not be construed as financial or legal advice. The reader should consult with his or her own advisors.