Download Simplifying the LDI story by focusing on the three DB hedge ratio

OPINION
Simplifying the LDI story by
focusing on the three DB
hedge ratio levers
Justin Owens
By: Justin Owens, FSA, CFA, EA, Senior Asset Allocation Strategist
I have met with dozens of plan sponsors over the last several
years and most of them are weary of the burden their defined
benefit (DB) plan has placed on their company. Common
complaints include unexpected contributions, balance sheet
volatility and increasing expenses.
Sponsors are looking to manage these risks through both funding and investment policies;
liability-driven investing (LDI) has become an important part of the toolkit. However, for
some, the LDI “story” is complex, and I have found that a simple framework for explaining
LDI in terms of three “levers” can be a helpful way of streamlining the key decision points.
The levers identify key choices that sponsors can control in the investment portfolio.
These levers explain how a sponsor can help mitigate some of the plan’s risks, particularly
interest rate risk. A simple way to measure how well a sponsor has managing their interest
rate risk is the “hedge ratio,” represented by this formula:
Hedge ratio formula
LEVER 1
Funded Status
LEVER 2
LDI Allocation
(Contributions)
Hedge Ratio
=
Assets
Liabilities
×
LDI Assets
Assets
LEVER 3
Duration Ratio
×
LDI Duration
Liability Duration
Sponsors desiring to increase their hedge ratios have three key levers to pull. These three
levers encapsulate perhaps the most influential tenets of funding and investment policies,
and each is within the plan sponsor’s control.
1. Funded status. Contribute to the plan to improve funded status and to increase
LDI (high quality fixed income) assets. Contributing cash always helps funded
status, and it can advance the hedge ratio insofar as it increases LDI assets.
2. LDI allocation. Reduce exposure to return-seeking (equity-like) assets in favor of
LDI assets. Doing so can have a more immediate and meaningful impact on the
hedge ratio than contributions alone.
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3. Duration ratio. Increase the duration of the LDI assets. Increasing LDI duration
– perhaps even beyond liability duration – can have the same effect while only
minimally impacting the expected return on assets. This “hedge long first”
strategy is designed to help sponsors get the most hedging potential out of their
LDI allocation. While sponsors may relinquish some upside if rates dramatically
increase, they will likely experience improved funded status stability, which may
help reduce the chance of surprises—an exchange many sponsors are willing to
make.
To meet their risk
management
objectives, sponsors
ought to first focus
on the three hedge
ratio levers.
To meet their risk management objectives, sponsors ought to first focus on the three
hedge ratio levers. While hedge ratio is not a perfect measure, and we can certainly dive
deeper to further refine LDI strategies. Understanding the impact of these three levers
puts sponsors on the right track to effectively manage their DB plan risk through sound
funding and investment policies.
Liability-driven investing is not the only way in which sponsors are managing their DB
plan risks. Investment policy works in concert with benefits policy, and many sponsors
have responded to increasing costs and uncertainty by closing or freezing their plans.
Others have changed plan designs or made other modifications to the benefits policy.
Looking back 10 years, many plans were fully funded but had not adopted an investment
strategy conducive to maintaining that funding position. As plans work their way back to
full funding, sponsors ought to consider which levers to pull to avoid repeating that
history.
This article is a condensed version of a recent paper, the full version of which is
available here.
For more information:
Call Russell Investments at 800-426-8506 or
visit russellinvestments.com/institutional
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First used: February 2017
AI-24846-02-20
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