Liability-Driven Investments & Risk Assets
Pension plans usually approach Liability-driven investing (LDI) as a two step process, where they first construct a bond portfolio that matches the risk profile of their liabilities using a predetermined fraction of their assets, and then allocate the remaining fraction to risk assets, such as equities, real estate, and private equities. Frequently, the allocation among the risk assets is performed independently of the liabilities and is strongly tilted to equities.
This two-step approach might be appealing from a mental accounting perspective, but we believe it is suboptimal. The remaining unhedged portion of the liabilities interacts with risk assets in generating surplus (or funded status) risk. Therefore, plan sponsors should consider allocating their risk asset portfolios in a way that explicitly integrates liabilities, consistent with the approach they use to build their bond portfolio. In other words they should take into account correlations between risk assets and liabilities. To the extent that the unhedged portion of the liabilities represents a short duration exposure of the plan, it may be optimal to allocate to risk assets that carry positive duration exposure, such as emerging market debt and private equity, in addition to equities.
The risk factor perspective
- Asset allocation, liability modeling, and immunization analysis are non-trivial endeavors. Integrating all three requires considerable effort. Liability valuation itself, and the measurement of surplus, while exact from the perspective of accounting and actuarial standards, are only approximations of the underlying economics of meeting liability payments over the next 30 to 100 years.
- A key tool in successfully integrating asset allocation, liability valuation, and immunization is the risk factor perspective. Risk factor analysis decomposes assets and liabilities into their fundamental “risk off” and “risk on” building blocks. Because they are discounted on the AA curve, liabilities are exposed to a “risk off” factor (duration, i.e. interest rate risk), as well as a “risk on” factor (credit spread risk). Of course, the duration exposure is the dominant of the two.
Diversification in times of market stress
- To assess diversification across assets and liabilities requires careful analysis of correlations during times of market stress. Indeed, it has been widely observed that correlations in down markets differ from correlations estimated from the full sample of returns. Therefore, full-sample correlations can overstate – or understate – a risk factor’s diversification properties in market environments when diversification is most needed. The duration-equity and credit-equity correlations are especially sensitive to this effect.
Empirical evidence suggest that duration and credit have diversified equity risk away over long time periods (both correlations are low and slightly positive: 0.08 for duration and 0.03 for credit). However, during tail events, duration typically experiences a flight-to-safety rally, while credit spreads widen significantly. Historically, tail event correlation between duration and equities is - 0.48, compared to +0.82 for the credit risk factor.
- From an asset-only perspective, the obvious conclusions from this correlation analysis are that: a) in a risk sell off, the portfolio may benefit from a rally in Treasuries, and b) credit is a poor diversifier of equity risk in the portfolio.
- From an asset-liability perspective, these duration diversification dynamics must be interpreted carefully – most plan sponsors are short duration because their liabilities have longer duration than their total asset portfolio. If rates rise, they may benefit. But for those plan sponsors, there’s no such thing as a flight-to-safety diversification effect between duration and equities. During a “risk off” event, those plan sponsors will likely experience two averse effects: their equity portfolio will likely lose value and their liabilities will grow faster than their bond portfolio on a nominal basis. Hence, plan sponsors who wish to reduce their funded status risk should consider increasing allocation to Treasuries and recognize their funded status may benefit from a rally in duration during equity drawdowns only once they become net long duration.
- Plan sponsors that are unwilling to increase duration or face constraints in this regard should pay special attention to identifying alternative sources of diversification within their risk assets.
When diversifying across risk assets, there are choices that may be more attractive to pension plans than they are to investors in the asset-only space, such as risk assets with exposure to duration. This duration exposure may take the form of explicit fixed income positions or to private and illiquid asset classes whose valuations are strongly linked to present value discounting processes.
A diversified portfolio of alternatives
- Plan sponsors who choose to maintain a short duration stance on a total portfolio basis should consider alternative sources of diversification beyond equities, and they should focus on risk assets with indirect duration and credit exposures.
- Diversification benefits may be achieved by substituting a portion of a plan’s equity portfolio for commodities, emerging market local debt and absolute return strategies.
- Q.M.S advisors helps plan sponsors identify efficient substitutes to equity risk allocations and define optimal allocations based on multiple risk factors in surplus space. Our opportunity costs of implementing a risk reducing allocation in surplus-space is expressed as a return differential between the initial "naive" allocation and our optimized risk-reducing solution.
In general, from an LDI perspective, plan sponsors that are constrained or choose to remain short duration may want to consider risk assets that offer alternative sources of equity risk diversification, such as commodities, as well as assets with stable cash flows – and hence greater indirect duration and credit exposures – such as high-dividend stocks, real estate, infrastructure and some hedge funds. Duration exposure from markets that are not at their zero-bound and for which debt-to-GDP levels are reasonable, such as emerging market bonds, may also provide incremental returns while reducing risk to the funded status. In all cases, plan sponsors should carefully evaluate correlations in times of stress before optimizing their portfolio.