Liability-driven investing (LDI) strategies have grown increasingly customized to better match the bespoke nature of pension de-risking programs.
Still, common ground remains among these tailored approaches.
For example, a significant number of plan sponsors have integrated glide path strategies into their overall pension risk management framework to
gradually reduce their plan’s risk exposure as their funding ratios improve.
The glide path concept may appear relatively straightforward in theory: Monitor your funding ratio and shift assets from the return-seeking portfolio
to the LDI portfolio when pre-established funded status triggers are achieved. In practice, however, the operational complexity and burden of
coordinating asset flows between several managers and recalibrating LDI portfolios to achieve new hedge ratio targets when a trigger is achieved can be
This is especially true considering that this transition must occur quickly to reduce the possibility that funding ratio gains evaporate before the
transition is completed (i.e., market movements that led to funding ratio improvement could mean-revert before the transition is completed). In
addition, especially for larger plans, the liquidity dynamics of the long credit fixed income markets could significantly lengthen the time required to
execute the shift from the return-seeking portfolio to the LDI portfolio and increase the risk that funding ratio gains erode before the transition is
To overcome these challenges, plan sponsors should consider pre-funding glide path triggers by purchasing in advance the assets that are likely to take
more time (or be more difficult) to acquire when a trigger is met, while adjusting the plan’s beta exposures (to offset the impact of the pre-funding
transaction) using synthetic, or derivatives, instruments.
Pre-funding glide path triggers: How does that work?
Let’s assume a plan has $5 billion in liabilities and $4 billion in assets (i.e., a funding ratio of 80%). Let’s also consider a hypothetical glide
path that calls for shifting approximately 5% of plan assets toward LDI every time a funding ratio trigger is met. This would suggest a need to
purchase approximately $200 million – $275 million in long-duration fixed income at each trigger point (including approximately $150 million – $210
million in long credit bonds if we assume a 75% long credit/25% long government LDI portfolio).
Given the operational complexities in executing the shift in asset allocation and recalibrating LDI portfolios (which would affect almost every plan)
and the liquidity dynamics of the long credit market (which would mostly affect large plans), it may take a certain amount of time to execute
transitions required by the glide path. During this period, the plan’s risk exposure would be higher than what is suggested by the glide path, thereby
increasing the risk of missing an opportunity to lock-in funding ratio gains.
To overcome this challenge, plan sponsors might consider a more active approach instead of simply “waiting for the next trigger(s)” to take action.
With this approach, the plan sponsor would liquidate a certain amount of equity holdings immediately (i.e., would NOT wait for the next trigger to sell
physical equities) and use the proceeds to gradually buy the long-duration bonds that will ultimately be required when the next trigger is hit. This
transaction, when considered in isolation, would leave the sponsor in an underweight equity position and an overweight duration position (versus glide
path targets) due to the equity sale / bond purchases.
Fortunately, it is relatively straightforward to correct this mismatch using synthetic instruments or derivatives.
At inception of the trigger pre-funding strategy, exposure to the equity market would be reinstated using derivatives instruments for a notional
equivalent to the exposure lost through the physical equity sale. Proceeds from the physical equity sale would be used as collateral for the synthetic
equity position (and to meet margin flows). From there the proceeds of the physical equity sale would be gradually invested in long-dated bonds but the
resulting duration exposure would be negated (likely with pay-fixed interest rate swaps) to prevent deviations from the plan’s duration exposure
Once the bond purchases are completed, our hypothetical plan would essentially sit on approximately $200 million – $275 million of duration-hedged
long-duration bonds backing an equal amount of synthetic equity exposure. When the next trigger is achieved, the transition would be straightforward
and quick as it would only entail removing exposure to the synthetic equity and pay-fixed swap positions (which could most likely be completed in one
day). This approach would increase the likelihood that the plan successfully locks-in funding ratio gains as they arise and limits or eliminates the
risks associated with trying to place large sums of money in the long credit markets over a short horizon. In the meantime, until that next trigger is
actually hit, the plan’s asset allocation remains consistent with the plan’s glide path targets.
Depending on the pace of potential rate increases, plan sponsors may hit several funding ratio triggers over a short period of time (see summer of
2013). Therefore we would typically recommend pre-funding more than the next trigger. In general, for a glide path with a 3%–5% asset allocation shift
at every trigger point (from the return-seeking portfolio to the LDI portfolio), we would recommend implementing the strategy on approximately 10%–15%
of plan assets, essentially pre-funding the next three triggers. Early in the glide path, once a trigger is hit and the overlays are removed on 3%–5%
of the allocation, the plan sponsor should build the allocation back toward the initial 10%–15% target (by selling another 3%–5% of equities and
gradually buying the duration-hedged long bonds). However, as we move closer to the end of the glide path, the allocation to the trigger pre-funding
strategy would be allowed to slide down as triggers are achieved, aiming to hit 0% at the end of the glide path.
Addressing the caveats
Because the underlying pre-funded long bonds would serve as collateral for synthetic equity exposure and may have to be used for margin calls, it is
important to maintain appropriate levels of liquidity to ensure that potential margin calls can be met. As such, there is a limit to how much of the
underlying pre-funded bond portfolio could be invested in credit (in other words, we need to maintain a minimum level of liquid government bond
exposure). Based on historical volatility analysis and our own experience, we think the underlying pre-funded bond portfolio could get relatively close
to the 75% credit weight used in the example above. To be precise, we believe that the underlying pre-funded long bond portfolio could own as much as
65% in long credit for each pre-funded trigger. Therefore, once the trigger is hit the transition would require a slight adjustment of the credit
versus government weight of the bond portfolio (to bring it from the 65% weight to the 75% target in our example) in addition to removing the synthetic
exposures. Ultimately, we believe this is a relatively minor hindrance as the strategy still enables the sponsor to pre-fund a large majority of the
future long credit bond purchases (almost 90% of the ultimate 75% target in our hypothetical example).
It is also important to recognize that while the incremental interest rate risk exposure of the pre-funded long bond purchases would be hedged (i.e.,
mitigated or eliminated) via pay-fixed swaps, the incremental credit exposure would remain. Therefore, the plan would have a slight overweight to
credit (approximately 0.5 years – 0.75 years of credit duration per trigger pre-funded). Most plan sponsors would likely consider this a minor issue
given the relatively small deviation, because incremental exposure actually reduces the spread mismatch versus liabilities and since that exposure may
be compensated with incremental spread income. That said, for those who remain concerned about this potential credit overweight, it could be mitigated
through the use of credit derivatives.
Get ahead of your next trigger
While the glide path framework appears simple in theory, its execution and coordination is complex in practice. To alleviate the execution complexity
and achieve a smooth and efficient glide path progression plan, sponsors should consider a trigger pre-funding strategy. This strategy will simplify
execution throughout the glide path, limit the challenges associated with the need to quickly acquire long credit bonds and ensure prompt
crystallization of funding ratio gains. Combined, these three benefits will increase the likelihood of a smoother glide path progression.