Jeroen van Bezooijen of PIMCO looks at how a different approach to overlay strategies can aid pension funds in this difficult economic environment
While liability-driven investing (LDI) generally proved its value by protecting funding positions through the recent crisis, many LDI overlay strategies – implemented to reduce asset-liability mismatch risk – are not structured or managed in an optimal way. A ‘next generation’ of overlay strategies based around four key improvements over existing methods – greater implementation flexibility, a more dynamic and consultative approach, simpler solutions and more transparent fees – may help pension schemes counter the challenges posed by the new normal investment environment. This New Normal will, in our opinion, be characterised by factors such as lower growth rates, increased market volatility and the reoccurrence of “market accidents”.
During both stable (2004 to mid-2007) and turbulent (mid-2007 to present) market conditions, LDI overlay strategies have generally served pension funds well. For example, in 2008 pension liabilities increased by up to 15% at the same time that equity values collapsed, a situation often termed the ‘Perfect Storm’ for pension schemes. Most LDI strategies, with their focus on extending duration (and in many cases also building up inflation exposure), performed relatively well and significantly dampened the fall in funding positions. However, we believe LDI has the potential to add even greater value via four improvements in the approach to structuring and managing overlays.
A more flexible and dynamic approach
First, the next generation of overlay strategies will incorporate greater flexibility in implementation. The recent crisis highlighted that there are often many dislocations in the market, which means that a narrow focus on swaps as the implementation mechanism leads pension schemes to miss opportunities for optimal implementation of the LDI ‘beta’. The traditional structure of hedging interest rate and inflation risk with swaps, and investing the ‘collateral’ in floating rate assets to generate the floating leg (LIBOR) on the swaps, has not achieved the targeted results.
This was partially due to the six month LIBOR rate rising relative to shorter interest rates, and also due to how ‘LIBOR’ portfolios generally focused on securitised investments because these pay a ‘LIBOR coupon’. During the recent crisis, many of these assets traded below par, causing LDI portfolios to fall behind the liabilities they were designed to match. Also, the long end of the swap curve has seen rates below government yields for the past 9 to 12 months, an abnormal situation because swaps embed a higher credit risk than government bonds.
A more flexible approach can determine a more efficient way to implement the LDI ‘beta’. For example, in the current environment, an overlay strategy is more efficiently implemented through government bond repo positions than through swaps.
Another example of a flexible approach to overlay strategies is the use of equity index derivatives, typically low-cost futures and swaps, to achieve non-leveraged passive stock market exposure, while investing the remaining cash in an LDI portfolio designed to mimic the client’s liabilities. This approach may offer a higher yield on the underlying portfolio together with the potential benefits of better alpha opportunities in fixed income markets compared to equities.
A second feature of the next generation of overlay mandates is a more dynamic and consultative approach. Many existing overlays fall short because investors and managers implemented LDI overlays in a passive, rigid way, based on the view that these strategies were simply about getting market exposure, and a low-cost passive approach was the most appropriate method. However, the optimal LDI strategy for a funding position in the 90% to 100% range (for example) is likely to differ from one at a 60% to 70% level.
When markets and circumstances change, LDI strategies often need adjusting as well. In a consultative approach, the overlay manager works with the client to review the overlay periodically. This review should incorporate both the overall pension scheme strategy (should the overlay be changed to better reflect the pension scheme’s objectives?) and both short- and long-term market views (is now the right time to change the overlay?).
Simpler and more transparent
Simpler, risk-based solutions are a third component of the next generation of LDI overlay strategies. Currently, many LDI structures are directly driven by the liability cash flow projections. This has typically resulted in overly complex solutions that overlook two things: liability cash flows are only estimates and subject to a considerable amount of uncertainty, and LDI overlays are not one-off solutions and will need to be adjusted if the pension scheme’s strategy changes. Because of the solutions’ complexity, restructuring them when necessary turns out to be difficult and costly.
Simpler solutions would focus on matching key risk factors: It makes more sense to focus on the liquid securities and maturities across the curve by identifying the key risk drivers, and then building a portfolio of these liquid instruments that has the same risk factor exposures as the liabilities. This results in simpler and more liquid portfolios, and lowers transaction costs.
The fourth feature of next generation overlay strategies will be transparent charging, and a fee structure that is not based on transactions. When the fee structure is transaction-based, the charges paid by the client are often not transparent, and providers are incentivised to restructure overlays to generate fee income. This clearly does not align the provider’s interests with the client’s.
LDI investors and managers who can readily adapt their approaches and incorporate these improvements are likely to be better positioned to face the long-term challenges of the described New Normal global economic environment.