According to Wall Street Journal reporter Mark Cobley ("Crunch hits complex pension investments," September 4, 2008), Liability-Driven Investing ("LDI") strategies may be creating some unexpected pain for pension funds. Touted as a way to mitigate risk, LDI depends on relatively stable market conditions. Recent volatility has upset the apple cart.
In some cases, a defined benefit plan enters into an interest rate swap as what is referred to as a Fixed Rate Receiver, Floating Rate Payer. Structured properly, this effectively creates a hedge against adverse interest rate moves. When interest rates fall, a defined benefit plan liability goes up but is meant to be offset by a floating rate swap obligation that goes down. (This is a gross simplication, ignoring yield curve differentials and shape, along with multiple factors that influence the size and timing of pension payouts. Additionally, a swap is usually structured to have the underlying pension liability "cash flow matched" so that the fixed rate swap receipts cover the pension IOUs.)
Unfortunately for some, worsening credit problems have led to higher LIBOR (London Interbank Offer Rate) rates, a standard floating rate swap benchmark and one gauge of the rate at which banks borrow and lend money to each other. As LIBOR goes up, floating rate swap outlays rise, negating part or all of the inherent benefits of having entered into the interest rate swap in the first place.
Another variation of LDI (and there are many) requires a pension fund to add "portable alpha," usually in the form of a hedge fund or "equitized" or "enhanced" money management fund. Essentially this is done to lower the opportunity loss when an asset allocation mix veers towards fixed income, away from equity. (This assume a positive equity risk premium whereby equities return more on average than "comparable" risk fixed income securities.) Quoting a Schroders LDI expert, Mr. Andrew Connell, increased LIBOR rates cause "the value of the assets drop and it becomes very difficult to meet benchmarks in the short term."
One solution discussed in the article is for pension plans to invest in offerings that guarantee a rate, tied to LIBOR plus a basis point spread. While it sounds good on the surface, it means that "the pension scheme invests in a portfolio of assets currently held on the bank's balance sheet, such as leveraged loans or asset-backed paper." Since we all know that nothing is free, the question becomes - What risks does a pension investor assume if this revised strategy is adopted?
On top of everything else, investment fiduciaries must properly benchmark their chosen LDI strategy, something that is easier said than done. For example, does one track the difference between required cash flows (owed to plan participants) and LDI "net" cash flows? Life remains a challenge for those now contemplating (or already taking the plunge) whether "to LDI or not to LDI."