Recently, my weekly supply run to the local warehouse store was unexpectedly interrupted by a life changing event. As I turned the corner with my oversized cart, finishing off the remnants of the free buffalo chicken from the last aisle, there it was. Football…in wide screen, glorious 4K HDTV!
After the initial euphoric shock wore off, I was beset by so many questions! Is grass really that green? What sport have I been allegedly watching all these years? Does that fan in the front row know he has nacho cheese on his shirt?
The driver of 4k visual awesomeness is the number of lines that make up the picture. Early high definition (HD) TV pictures are made up of 720 horizontal lines. “Full HD” consists of 1,080. Now, before me at the big box club was a 4k picture featuring 2,160 lines* – twice as sharp as my set at home.
The evolution of liability driven investment (LDI) offerings is similar to that of HDTV.
“Standard Def” LDI
The initial investment approach to implementing LDI was to simply increase allocation to a long term bond fund. By investing in a long bond fund (with a targeted duration of 10 to 15 years) sponsors found that their fixed income holdings would react to rate changes a lot like their liabilities. The result: less volatility on their balance sheets.
Those early pioneers of LDI discovered that long bond exposure indeed worked to reduce risk. But once that fact was established, the race to refine the LDI experience kicked into high gear much like the race to improve HDTV.
“Full HD” LDI Investment Options
Real application of LDI led to deeper thought regarding pension cash flows and yield curve behavior. While it was true that long bond exposure generally immunized interest rate risk, it did so by matching the aggregate duration of the entire plan. This approach can be very effective when rates move up or down in a parallel fashion across the entire yield curve, but produced larger “tracking errors” (asset returns varying from liability returns) when yield curves changed shape by flattening or steepening.
This led to the construction of families of LDI investments specifically designed to match liability duration at several points along the yield curve. So instead of a single bond fund matching the entire plan’s liability, a series of funds occupying distinct key rate durations along the yield curve could be aligned with specific segments of the liability. (For example: four distinct investments covering short, intermediate, long, and extended duration segments along the curve.)
Like an improvement in HD resolution, matching with four investments instead of one can improve the sharpness of the duration matching characteristics of an LDI strategy. Overall tracking error can be lower because the four separate investments typically behave more like liabilities regardless of whether yield curves move in parallel fashion or twist significantly.
“4k” Custom Bond Portfolios
Logic would dictate that if four investments have lower tracking error than one, then matching more points of duration could improve tracking error even further. Customized bond portfolios can be the LDI investment equivalent to this ultra-HD experience.
Rather than being composed of commingled funds, a custom bond portfolio is constructed of individual bonds that can be specifically tailored to plan cash flows at every year along the entire yield curve. So instead of matching duration at one or four points, it can be aligned at 20, 50, or 100 points.
Besides theoretically delivering lower tracking error, custom bond portfolios can have additional advantages.
- Sponsors exercise more control over the timing of purchases and sales of bonds.
- Individual bonds are owned by the plan so they can be transferred easily between trustees as needed.
- And, with sufficient planning, the bonds can even be used as in-kind assets to purchase annuities within risk transfer strategies, potentially reducing transaction expenses.
Which LDI Do You Really Need?
Human beings seem driven to continually refine the inventions of others. We also seem inclined to want the latest and the best of everything.
But let’s face it, we don’t all need 4k HDTV all the time. Live hockey games look fantastic (Go Pens!!). I Love Lucy reruns not so much. And close-up news anchors can be downright scary!
So how “High Def” of an LDI experience do sponsors really need? That depends on several factors, including:
- Size of the plan assets and liability relative to the plan sponsor
- Status of the plan (ongoing vs. frozen)
- Sensitivity of the plan sponsor’s business to interest rate risk
- Desired LDI “tightness of fit” (which often corresponds to the plan’s funding ratio)
- Portion of portfolio allocated to fixed income
- Expenses associated with each investment option
Generally, larger tracking errors are acceptable (and possibly preferable) when plan funding ratios are lower and portfolios more likely to be heavily allocated to equities and other return seeking investments. In these cases, a single long bond fund may do just fine.
As plan funding ratios improve, especially for frozen plans looking to terminate, tracking error takes on increased importance. The emphasis of the investment strategy shifts from catching up to protecting against downside risk. And when pension liabilities are relatively large, even small tracking error improvements can be meaningful.
Back at the store, after checking the price tag I decided to stick with the old TV in the family room for a while. I’ll be back for 4k some day, but for now the picture at home is sharp enough for me, and it’s fully paid for!
Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA) and a shopping club our compliance department will not let him disclose by name.
* I was wondering how 2,160 horizontal lines wound up being called “4k”. The answer (according to Wikipedia) is that the 4k picture has 3,840 vertical pixel lines which is rounded up to 4,000 for marketing purposes. (Close enough for an actuary!)
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
Investing involves risk, including possible loss of principal.
Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline.
This document is intended to be educational in nature and is not intended to be taken as a recommendation.
Insurance products and plan administrative services are provided through Principal Life Insurance Co., a member of the Principal Financial Group®, Des Moines, IA 50392.