Short-term focus needed to get long duration exposure

Despite recent volatility in equity markets, pension plans looking to transition to a liability-matched investment portfolio need to be proactive to mitigate the risk associated with the move, a US-based consultant has advised.

Russell Investments head of fixed income transitions, Travis Bagley says many of their defined benefit corporate pension fund clients are looking to make the move into liability-driven investment strategies but face a difficult transition.

“These plans want to make a decision to go to long duration but it is in an environment where interest rates are extremely low from a historical standpoint,” Bagley says.

“So, it is a behavioural finance issue where right at the point where they (pension plans) are ready to go into long duration assets there is the prospect out there that market interest rates are going to rise, so if you invest in those long duration assets and rates do rise than the value of your assets will go down.”

In a recent white paper Russell Investments investigated a range of strategies to move from a traditional asset-focused portfolio strategy that typically may have 60 per cent in equities and 40 per cent bonds to a liability-driven asset allocation.

“This is one of the riskiest transactions that any plan can undertake because you are selling the equity asset class and buying long duration fixed income asset class,” Bagley says.

“The correlation of these two asset classes is very different, they are not correlated at all, and the performance between one and the other can be very different in those asset classes.”

Bagley says the pension plans looking to make the transition are usually defined benefit corporate pension plans with assets of more than $1 billion.

The clients Russell Investmens are typically advising on making the LDI move are larger funds, with up to $50 billion in assets, Bagley says.

Russell Investments found the most popular tactic for making the transition is to use a mixture of government and corporate bonds and futures.

While Russell reports swaps are being used, the lingering fall-out from the financial crisis has meant concerns over counterparty risk made this a less desired method for gaining long duration exposure.

Bagley says the most popular instrument to use is long maturing corporate bonds because their yield rates most closely match the rates at which liabilities are discounted.

With strong demand and a shortage of supply for high quality corporate debt, Bagley says this type of fixed asset looked good for funds over the long-term.

“If a plan has implemented their long duration credit tilt already, they are sitting in a good place,” he says.

The average duration for LDI mandates is 10 years or more, with many funds still only at the beginning of this transformation in their asset allocation.

“Right now those plans are only at about the 3 to 3.5 year-stage so there is definitely a significant amount of move that needs to happen,” Bagley says.

“So, we are only a third of the way there so there is another two-thirds of the way to go for these funds to get to their ultimate end goal.”

The white paper looks at two transition strategies. The first, a so-called “idealist” strategy is where once the plan made a decision that interest rate hedging is appropriate, it moved immediately to an LDI strategy.

The “idealist” plan will then make asset allocation changes with derivatives and work into a physicals (fixed income instruments) portfolios over time.

The second strategy, the so-called “harm minimiser” looked to dollar cost average into LDI over time, using a mix of derivatives and physicals.

“Many of the plans we talk to don’t necessarily want to go into the LDI solution all at once, they would rather dollar cost average into it over a longer period of time,” he says.

“That may mean six months, a year or even multiple years rather than taking on all of that long duration exposure at once. Maybe over a scheduled 12-month horizon makes more sense to them.”

Another version of this “harm minimiser” approach that Russell is seeing is to transition in stages.

This approach takes a given percentage hedge ration, say 45 per cent , and moves to that immediately with whatever physicals, futures, and swaps that is cost optimal. Then the pension fund will pick a time in the future for when they plan to bring its hedge-ratio up to its long-term desirable level.

Bagley says the majority of the funds Russell is talking with had chosen to go down the “harm minimiser” route, with either a dollar cost average or staged approach.

The strategy and tactics a pension plan uses to transition to LDI will depend on a range of things including the funded status of the plan. The make-up and personality of the investment or oversight committee is also crucial, in particular how they react to the significant impact on asset values from rising rates.

Despite the difficulties in making the move, Bagley says plans needed to take positive steps to reach their long-term interest rate hedging goals.

“We would like to see plans be more proactive in moving into long duration but there is also the behavioural finance question, which is: is this the right time to make the move, and most plans would also like a calm or somewhat less volatile market to make this transition,” he says.