KNOWLEDGE CENTER

The Pension Management Research Panel recently conducted the 4th Annual Global Quick Poll on Liability Driven Investing (LDI). The poll was completed by 110 pension executives from the Netherlands, United Kingdom and United States. The executives oversee pensions ranging from U.S. $30 million to more than U.S. $5 billion in assets. The aim of this poll and this summary is to examine how perceptions around LDI strategies have changed during the past four years. Additionally, the poll sought to understand the impact that ongoing market volatility has had on LDI strategies.

Section I - The Current State of Liability Driven Investing

• Adoption of LDI strategies has decreased from last year but remains higher than previous years
In 2007, 20 percent of polled organizations said they were employing an LDI strategy within pension investments. In 2008, more than one-third (37 percent) employed LDI strategies and in 2009 more than half (54 percent) utilized LDI strategies. This year, the number dipped a little to half (50 percent) but still remained high compared to 2007-08.
• More implementations this year
Ten percent of those not currently employing an LDI strategy said the organization would be by the end of 2010.
• LDI strategies could see an increase next year
Nearly half (40 percent) of those not currently implementing an LDI strategy said the organization is considering employing such an approach in 2011.
• Some not even considering an LDI strategy
A quarter (25 percent) of the poll participants said the organization is not currently implementing an LDI approach nor are they considering such an approach at this time.

U.S. Highlights:
In the U.S., the percentage (50 percent) of poll participants that are currently implementing an LDI strategy remained virtually the same as 2009 (51 percent). During the past three years, there has been a large shift toward utilizing an LDI strategy. In 2007, less than one-fifth (17 percent) used LDI and in 2008, that percentage grew to more than one-third (36 percent).

Section II - The Goals and Objectives of LDI

How do pension executives define LDI?
When the first LDI poll was conducted in 2007, one of the ongoing public debates about LDI was whether it is a specific strategy or if it is a broader context under which a number of different strategies would qualify. Each year, poll participants continue to validate that LDI is widely considered a variety of strategies customized to a specific organization and its goals. Over the past four years the most popular definition according to poll participants has shifted between “a portfolio designed to be risk managed with respect to liabilities” and “matching duration of assets to duration of liabilities.”

The following chart shows a breakdown of the popularity of these definitions, with the highest-ranking definition each year highlighted in orange.

U.S. Highlight:
The number of U.S. participants selecting “matching duration of assets to duration of liabilities” as the best definition of LDI decreased from 52 percent in 2009 to 38 percent in 2010. In contrast, “a portfolio designed to be risk managed with respect to liabilities” increased from 27 percent last year to 33 percent in 2010.

What are the objectives of LDI?
Ongoing market volatility coupled with fluctuations in interest rates has led those overseeing pensions to consider a variety of investment strategies to gain more control of funding levels. As pensions consider the adoption of LDI strategies, the objectives of those strategies must be aligned with the objectives of the pension and the plan sponsor. For the fourth consecutive year, poll participants were asked to identify what they felt were the primary objectives of an LDI strategy and for the fourth straight year, the most popular response was to “control year-to-year volatility of funded status.”

The number of respondents identifying this as an objective has grown since the first year of the poll; however, the overall percentage decreased from last year. In fact, of the five objectives of LDI, four saw a lower percentage of respondents choose that objective this year when compared to 2009. This was quite a contrast from last year when of the five objectives of LDI, four saw increased percentages. In 2010, the only objective to see an increase in percentage of respondents identifying it as an objective was “improve funding levels.”

The following chart illustrates what poll participants felt were the primary objectives of an LDI strategy and how the overall percentage that selected each objective has changed year by year: 

What are the benchmarks for pension success and are they changing?
Over the past four years, this poll has asked participants to identify the primary benchmark for success of the pension’s investments. This year, 82 percent (vs. 85 percent in 2009) of respondents indicated their benchmark was tied to whether or not the asset pool provided some level of support to the liabilities.

Through the years, the poll has asked participants to identify specific benchmarks and the two most popular choices have consistently been “absolute return of the portfolio” and “improved funded status.” In 2007, “absolute return” was the highest-ranked benchmark with 28 percent of poll participants, followed by “improved funding” with 23 percent. During each subsequent year, those percentages continued to shift towards “improved funding,” peaking at 42 percent last year (compared to only 15 percent that said “absolute return”).

In 2010, the difference between these two benchmarks lessened slightly but still remains high as more than a third (38 percent) of all poll participants said the primary benchmark was “improved funded status.” Nearly a fifth (18 percent) said “absolute return of the portfolio,” which was a three percent increase over last year.

It is interesting to note that for the first time in the four years the poll has been conducted, “absolute return of portfolio” did not rank first or second among primary benchmarks. This year, 22 percent of the poll participants selected “minimize or control contributions,” thus surpassing “absolute return” as the second most popular primary benchmark.

The graphic below illustrates the contrast over the past four years between the percent of participants saying “absolute return” was the primary benchmark versus those saying it is “improved funded status.” As the chart indicates, there has been a shift towards the latter as the measure of success for pension investments: 

 

Finally, the respondents seem to have more agreement in recent years on the benchmark for investment success. Although the actual choices for the top two benchmarks changed from previous years, a total of 60 percent of this year’s respondents chose one of the top two benchmarks. Last year, that number was a similar 57 percent after being as low as 42 percent in 2008 and 51 percent in 2007.

U.S. Highlights:
In the U.S., 33 percent chose “improve funded status” and 28 percent chose “minimize or control contributions” as primary benchmarks. The percentage difference between these two (five percent) was much smaller in the U.S. than the difference on a global level (16 percent). Also, 11 percent of U.S. participants chose “protect current funded status” as the primary success benchmark – more than in any other country.

Section III – Asset Allocation Decisions

How often are institutions making asset allocation changes and what factors are driving those decisions?
Pension portfolios have historically been viewed as long-term portfolios and therefore, asset allocation changes were somewhat infrequent. In the past, it was very common to have as much as five years pass before pension trustees reviewed and changed the portfolio’s asset allocation. The influx of new investment products over the past ten years saw some increased frequency but the market environment of the last two years has definitely caused a stir. Of the poll participants, less than a third (31 percent) said it has been more than a year since their last asset allocation change. More than a third (38 percent) said their organization made a change in the past six months.

The reasoning behind asset allocation changes often varies from one organization to another. The poll results suggest that the most common influence has been that consultants and internal committees who are reviewing investment policy statements and recommending changes.

The below graphic illustrates the percentages of poll participants that identified the following factors as drivers behind their most recent asset allocation change:

U.S. Highlights:
Nearly a third (32 percent) of U.S. participants said that changes to funding requirements or accounting standards drove their organization’s most recent asset allocation change to the pension portfolio.

Which investment products are increasing and decreasing in popularity?
Despite a decline in usage, long-duration bonds are still the LDI product of choice. Last year, nearly all poll participants employing LDI (98 percent) said they are using long-duration bonds as part of their LDI strategy. In 2010, the percentage of participants using long-duration bonds dropped considerably, to 75 percent. However, according to the poll results, long bonds are still the preferred investment product in LDI strategies by a far margin.

The second most common product this year was short-term cash management (used by 43 percent), surpassing interest rate derivatives for that distinction. In fact, the percentage of participants using interest rate derivatives as part of their LDI strategy declined significantly, from 40 percent last year to only 24 percent this year. In contrast, the use of emerging-market debt saw a significant increase this year, as 36 percent of those with LDI strategies said they were invested in this asset class (vs. 14 percent in 2009).

The below graphic shows a breakdown of the percentage of poll participants using the following products as part of their LDI strategy:

U.S. Highlights:
For the second straight year, U.S. participants paralleled global results regarding use of long-duration bonds. More than half of the U.S. participants (58 percent) said the pension currently invests in real estate, 28 percent invest in hedge funds and 23 percent said they are using interest rate derivatives.

Section IV – Additional U.S. Highlights:

Participants in the U.S. poll were asked some additional questions around the current challenges they face when it comes to pension management.

Strain on resources for pension investment management
The intricacies in pension investment management have only multiplied in the past few years and companies are beginning to feel the impact on their finance and treasury departments. As companies are trying to focus on their core competencies and overall business, pension investment management is requiring more attention from internal resources. Nearly half (46 percent) of U.S. poll participants said pension investment management has become more time-consuming, in part because of the necessary due diligence required when it comes to selecting money managers.

A separate portion of the U.S. research went directly to the leaders of corporate finance departments. Questions were posed to Chief Financial Officers and Treasurers regarding how their organizations view the risks and impact pension investment management is having on their internal departments. Following up on the above challenge of selecting money managers, this senior group was asked about investment outsourcing services as an alternative to the traditional consultant approach. They were asked to best describe their organization’s attitude towards investment outsourcing, where organizational investment resources focus on strategic initiatives for asset allocation while delegating the responsibility of researching and selecting managers for those allocations to an outside partner. Almost two thirds (63 percent) said they had at least a moderate level of interest in better understanding this approach.

Another area of concern was the fact that because organizations cannot dedicate significant resources to pension management, the sole responsibility rests with one or a handful of individuals. More than a third (38 percent) said that the information and strategic execution related to the pension plan rests with a few key personnel and that expertise is at risk if one or more of those individuals leave the organization.

Active asset allocation is a necessity in today’s environment
The challenging investment environment of the past two years has shed light on the vulnerability of pension portfolios, resulting in an industry-wide discussion about how institutional investors can better implement risk management strategies. In response, pension plan sponsors are evaluating their processes for asset allocation decisions, overall portfolio construction and how the fund is rebalanced. The traditional opinion that the asset allocation for the entire pension portfolio can be set for the long term (with a rebalancing system in place) is shifting towards the belief that these long-term strategies should at the very least be complemented with a more flexible allocation that provides the option to execute on shorter-term strategies. More than half of those polled (54 percent) agreed that in today’s pension environment, portfolios need capabilities to exploit shorter-term market inefficiencies and opportunities to add return and/or mitigate risk. Just over a quarter (26 percent) of the U.S. participants “disagreed” that this strategy is needed while the remaining 20 percent were “neutral” on this subject.

More plans are closing to new participants and freezing accruals
Poll participants were asked to identify the current state of their organization’s pension and they were provided the following definitions as options:

• ACTIVE - The pension is active and open to new hires. 
• CLOSED - The pension is closed to new hires, however existing participants are still accruing benefits. 
• FROZEN - The pension is closed to new hires AND existing participants are no longer accruing benefits.

Frozen pension plans should use an LDI strategy
Per the above chart, more than one fifth (21 percent) of U.S. poll participants oversee pension plans that have frozen accruals for existing participants. Many factors influence the pros and cons for an organization to take this action but one primary benefit of freezing accruals is that the long-term liability of the pension becomes more set (versus active plans that experience a constantly changing liability).

In order to effectively terminate a pension, the plan must be fully funded and the plan’s funded status will continue to influence the investment decisions for the pension portfolio. That being the case, almost two thirds (63 percent) of U.S. poll participants feels that LDI strategies are completely necessary for plans that have already frozen accruals. Only 16 percent felt they were not necessary and 21 percent were “neutral” on this subject.

Are most pension plans going to be closed in ten years?
The discussion about the long-term viability of private-sector pension plans has been going on for at least the past decade. Over that time, the industry has seen an increase in the overall number of pensions closed to new entrants, and a good portion of those organizations have taken the additional step of freezing accruals. In fact, more than half (59 percent) of the U.S. poll participants said the organization has at least closed the pension to new hires. While these could be viewed as potential steps towards termination, there has not necessarily been a significant trend of plans being terminated. It is important to note that none of the plans in the global poll were terminated, nor had they taken any additional steps towards termination. While that is currently the case, the majority of U.S. poll participants felt that 90 percent of the pension plans open to new hires today will not be open in ten years. More than two-thirds (69 percent) of those polled agreed with the statement that “in ten years, the number of companies offering pensions as a benefit to new hires will be less than 10% of what it is today.” Only 15 percent disagreed with that statement while the remaining 16 percent were “neutral” on this subject.

Conclusion

Over the past five years, Liability Driven Investing (LDI) has continued to be a much discussed concept for pension plans around the world. While implementation has increased over that time, various market conditions dictate how widely these strategies may be used.

According to the poll, one of the primary goals of an LDI strategy is to try to control year-to-year volatility of the pension’s funded status by providing a return on assets that is aligned with the return on overall liabilities of the plan. As this continues to be a strategy utilized by pensions around the world, the increased emphasis on funded status has also changed the success metric for pensions. Today, more organizations view whether or not the asset pool provides support to the pension liabilities as the true measure of pension investment success.

As this mindset continues, pensions will look for investment tools that help best achieve this success metric.

Asset allocation changes are more common, and pension portfolios are using a variety of strategies including increasing allocations to fixed income, use of long-duration bonds, and use of interest-rate swaps. Long-duration bond strategies continue to be a popular strategy because bonds and liability values are similarly sensitive to interest rates. Current market conditions appear to have swayed investors away from the use of interest rate derivatives as they will be less effective than they have been in the past. More pension portfolios are turning towards short-term cash management and newer investment products such as emerging market debt as part of their overall investment strategies.

As more organizations attempt to improve funded status and design long-term strategies, LDI continues to be a concept embraced by pensions to help achieve that goal. The results of this poll show a trend towards acceptance and continued overall support for implementation of these strategies.

For more information, please email seiresearch@seic.com .

This information is for educational purposes only. Not intended to be investment, legal and/or tax advice. Please consult your financial/tax advisor for more information. Information provided by SEI Investments Management Corp., a wholly owned subsidiary of SEI Investments Company. ©SEI 2010