April 2014

EDHEC: The LDI paradigm

TruckIn the first of a two-part article, research from the Edhec-Risk Institute looks at the conclusions of a recent survey of the liability-driven investing practices of European pension funds. The liability-driven investing (LDI) paradigm that has arisen over the past two decades is a general investment framework that advocates the allocation of pension fund assets to two distinct portfolios: a performance-seeking portfolio and a liability-hedging portfolio, in addition to residual long or short investments in cash. Research conducted at Edhec-Risk Institute since 2008, in the context of the research chair sponsored by BNP Paribas Investment Partners, has outlined a number of important implications of this paradigm for the asset-liability management (ALM) of pension funds. In a nutshell, the main insight is to emphasise the benefits of dynamic forms of LDI strategies, which imply that the split between the risky performance-seeking component and the safe liability-hedging component should evolve over time as a function of changes in market conditions and also as a function of prudential risk budgets defined by the regulators, who have increased their focus on the respect of minimum funding ratio levels. In particular, such strategies are shown to allow for the respect of minimum funding ratio constraints with substantially lower opportunity costs compared to static LDI strategies. Having documented the benefits of the LDI paradigm and its extensions from a theoretical perspective, we have attempted through a recent survey to assess the views of pension funds, ALM consultants and sponsor companies as they relate to their reactions to dynamic LDI strategies and their desire to integrate this approach into their processes. Overall, the survey received a total of 104 responses, with a very large majority of participants (87%) emanating from Europe. Moreover, most of the respondents are pension funds managers. It is also worth noting that close to 80% of respondents has a high level of responsibility in their organisation, or are asset management professionals. Among the European respondents, some countries are largely over-represented, which of course reflects the larger development of the pension fund industry. The United Kingdom had 19 respondents, for example; Germany had 6. Having a significant number of respondents from the same geographical area is an asset because it allows us to analyse the differences in practices within this region. DB AND ASSET ALLOCATION
A majority of the pension funds (62.79%) that took part in the survey are defined-benefit (DB) pension funds, while the remaining funds are equally divided between defined-contribution (DC) and hybrid funds. This domination of DB funds has two important consequences for our study. First, most of the pension funds surveyed depend largely on the contributions from the sponsor, taken in a broad sense, as they can encompass contributions from both the employer and the employees.
The second consequence is that most of the pension funds that responded to the survey should in principle show some focus on ALM techniques that aim at respecting minimum funding requirements, in order to ensure that assets are sufficient to cover liabilities. Another important characteristic of the pension funds that we surveyed is their inclination to internalise the asset allocation process. 86.75% of them make these choices internally and rely on external managers for their implementation. DISCOUNT RATE PREFERENCE
The typically long maturity of pension liabilities makes their present value highly sensitive to the discount rate applied to payments. The results reveal that close to half of them use a market rate, while barely 30% of them employ a fixed rate. The preference given to a market rate over a fixed rate has important consequences for the design of a liability-hedging portfolio. A market rate is by definition time-varying, and these variations have an impact on liability values that can be measured by the duration of the liabilities. As a result, the volatility of the discount rate accounts for a large fraction of liability volatility. In fact, it explains the totality of volatility if payments are fixed in nominal terms, and it still accounts for the largest part if pension payments are indexed with respect to inflation. Hence, a meaningful liability-hedging portfolio has to provide a hedge against unexpected fluctuations in the discount rate. A first key insight from the survey is that 80% of respondents are now fully aware of the LDI paradigm. This figure suggests that this principle has become an accepted norm in ALM for pension funds. Since the LDI principle is deeply rooted in portfolio theory, this result can be taken as an indication that the gap between academic prescriptions and practice is narrowing on this particular issue. Nevertheless, only half of the participants actually implement a formal separation between the performance-seeking portfolio and liability hedging portfolios, although this rate is subject to substantial geographical variations: for instance, most respondents from the UK and in Denmark adopt it. The reason most often cited (43.75%) by respondents who follow this principle is that it simplifies the portfolio construction process. This result is not very surprising, since each building block in an LDI strategy has a well-defined role, which is the search for risk-adjusted performance for the performance-seeking portfolio, and low risk relative to the liabilities for the liability-hedging portion. MEASURING LIABILITY RISK
More generally, we also surveyed participants’ practices regarding the measurement and the hedging of liability risk. The results show unambiguously that liability risk is much more often measured than hedged. Only 20% of participants do not measure liability risk at all; this is a minority, but still a worryingly high percentage given that this measurement is an essential part of a sound asset-liability management process. Among the 80% who measure liability risk, shortfall probability and expected shortfall are popular measures, since at least one of them is adopted by slightly more than half of participants. On the other hand, when it comes to liability hedging, 54.02% of participants declare that they do not hedge their liabilities, which amounts to using an asset-only investment framework despite the presence of liabilities. A positive finding is that liability hedging is more widespread among those pension funds who discount their liabilities at a market rate (63.41%, versus 20% among those who apply a fixed rate), but it is still surprising to note that a large share of pension funds do not hedge their liabilities. Saad Badaoui is senior quantitative analyst, Romain Deguest is senior research engineer, Lionel Martellini is scientific director, and Vincent Milhau, deputy scientific director, at the Edhec-Risk Institute ©2014 funds europe

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