We recently read an article (actually a paid commercial) from a large asset management organization that declared that traditional LDI was dead and that “pension stabilization” was to become LDI 3.0. For those interested, LDI 1.0 was the investment by corporate America in long corporate credit. An LDI 2.0 strategy consisted of “customized hedging strategies” including adding derivatives, SWAPs, completion funds, etc. LDI 3.0 is according to this firm a means to re-introduce alpha-seeking assets in lieu of “low returning and increasingly inefficient LDI programs”. They refer to it as a more balanced approach. A careful blending of modest excess return and low volatility.
We, at Ryan ALM, are flattered by this pronouncement, since we have been espousing a strategy very similar to LDI 3.0 for decades. We have recommended separating liquidity or Beta assets from growth or Alpha assets forever. The Beta assets’ job is to fund benefits chronologically while buying time for the Alpha assets to grow unencumbered. Given the improved funding for pension plans, particularly private plans, we believe that sponsors should de-risk even more than before by adding to the Beta assets to de-risk liabilities chronologically. We absolutely agree with this asset management organization when they recommend that continuing to hold long-corporate credit is not a wise solution at the current level of US interest rates. Given the 39-year bull market in US bonds, we certainly don’t see much upside in holding long bonds that don’t necessarily provide the best hedge possible for DB plans. We remind everyone that the value in bonds is the certainty of their cash flows. The best way to apply this value is to cash flow match liability cash flows chronologically.
As a reminder, we believe that the primary pension objective should be to SECURE benefits at low cost and with prudent risk. Duration strategies don’t secure the promised benefits. They actually don’t even do a great job of matching liability durations with asset durations because durations change continuously and individual bonds are not impacted the same with changes in rates. The ONLY way to secure the promised benefits is either through a pension risk transfer (PRT) or through a cash flow matching (CDI) implementation. The CDI approach matches liability cash flows with asset cash flow in chronological fashion so that each month’s benefits (and expenses) are secured for as many months out as the allocation to the strategy will permit.
By implementing a CDI program (Beta assets) the pension system has improved liquidity to meet those monthly obligations, mitigated interest rate risk for the assets in the CDI program, reduced funding costs, and extended the investing horizon (bought time) for the alpha bucket to perform up to expectation. Furthermore, the CDI program (usually 1-10 years of benefit payments) will be far less sensitive to rising interest rates than the long-duration corporate credit used in LDI 1.0 helping to reduce the potential impact on the portfolio. We love the idea of creating a “sleep well at night strategy” that affords the plan sponsor and their advisors the comfort of knowing that liquidity is available when needed without having to force it during periods of market dislocation.
DB pension plans are critically important to the plan participant. Access to one is often the difference between possibly retiring or retiring with dignity. Great strides have been made to improve pension funding in all plan sponsor types since the Great Financial Crisis. It would be sinful to see this improved funding wasted by not reconfiguring the plan’s asset allocation to reflect the current market environment of excessive valuations for many asset classes. Keep your bond allocation short to intermediate given the current inflationary environment, secure your plan’s benefits, while buying time for the alpha assets to grow unencumbered. If this is pension stabilization – great! As indicated earlier, we’ve been doing this for decades. If you want to learn more we are always available to discuss. Good luck!