By all accounts, 2008 was a grim year for all institutional investors.  But it may have been even grimmer for pensions plans - most of whom were caught in the squeeze between falling asset values and rising liabilities.  As markets cut the knees out from under already weakened defined benefit (DB) plans, low interest rates added insult to injury by increasing the present value of their future pension payouts.

A recent report (free reg. req’d.) by Russell Investments called “What’s Next for LDI?” suggests that many beaten-up pension boards will finally take liability driven investing to heart in 2009.

Why?  Because for many companies, pension liabilities have now become so large that they now swamp the total market cap of some companies.  For example, Russell compares the pension liabilities of oil companies and airlines to prove the point.  Both types of companies have similar size pensions, but since airlines have smaller market caps, their “projected benefit obligation” is 150% of their market cap (vs. only 6% for the much larger oil companies.)  Astoundingly, the unfunded portion of airline pension plans alone is 40% of the market cap of the airlines themselves.

The report is pretty meaty but easy to comprehend and is worth a read for both LDI neophytes and LDI-ophiles.

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While liability-driven investing (LDI) has achieved some measure of celebrity over the past year, the concept still has a reputation for being of interest only to egg-heads and actuaries (apologies to egg-heads…okay, and actuaries).

About  a month ago, consultancy Mercer wrote:

“It seems like only yesterday that Liability Driven Investing (LDI) was an interesting academic idea with few “real world” proponents among pension plan sponsors. Now, LDI regularly makes the front page of pension industry publications and is widely accepted as a practical and effective risk management framework. Plan sponsors implementing LDI strategies were “mavericks” only a few years ago; now they are “cutting edge.” For such a new area, LDI seems to have more than its fair share of experts. And there is a surprising diversity of opinions on what it is and what best practices are.” 

The pace of change seems to be accelerating.  Poll results released last Friday by SEI Global Institutional Solutions show that the simple, traditional definition of the concept, “matching the duration of assets to the duration of liabilities” is giving way to a more holistic view that LDI is ”a portfolio designed to be risk managed with respect to liabilities.”

Although this sounds like the same definition delivered by a marketing person instead of an actuary, SEI says this “suggests a stronger understanding around the broader implementation of LDI”.  Curious about whether LDI was having a break-out year, we requested a copy of the full report.  Here’s some of what we learned…

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The results from a survey were released last week on a topic that will either interest you or bore you tears:  Liability-Driven Investing (LDI).  We’ve covered this topic here at AllAboutAlpha.com because one of its constituent parts is often a hedge fund or portable alpha strategy.

More on the survey below.  But first, if you do all you can to avoid this topic; you might be well served to give it a second chance.  Try looking at it this way…

Pension Liabilities: Del Boca Vista

Frank Costanza: Are you telling me there’s not one condo available in all of Del Boca Vista?
Morty: That’s right. They went like hotcakes.
Frank: How’d you get yours?
Morty: Got lucky.
Frank: Are you trying to keep us out of Del Boca Vista?!

Let’s say you’re Seinfeld’s Frank Costanza (George’s father) and you’re saving for a glorious retirement at Del Boca Vista, a well-manicured retirement community in sunny Florida.  It’s 1998 and you calculate that your annual savings plus a few good hedge fund investments will cover the costs of that dream condo (to be built some time in 2011).

Each year you meet with your financial planner who tells you that you’re on track for your dreams.  But somewhere around 2002, she tells you that despite a killer year for your hedge fund holdings, you’re coming up short on your goal of buying that condo.  Apparently the South Florida real estate market is going crazy.

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When institutions want to match their assets to their liabilities (i.e. their scheduled payments to pensioners), they have essentially two choices.  They can invest in a portfolio of bonds that has the requisite payment schedule or they can use an “overlay” - a swap contract that can single-handedly modify the duration of the assets in order to match liabilities.

But while the swap idea sounds enticing (it allows pensions to maintain their existing portfolios), it comes with a cost.  In this article from P&I, Goldman Sachs’ Chris Sullivan says many of their clients use swaps to start with and then opt to rejig the portfolio itself in order to match liabilities.  It turns out the swap requires a lot of collateral.  Reports P&I:

“Using an overlay strategy has a cost, however. The pension fund must post collateral for interest rate swaps. Many pension funds post a small amount at the beginning, then agree to post more collateral on the swap if interest rates increase. If interest rates decrease, the counterparty the fund negotiated the swap with pays collateral to the pension fund.

“Many pension funds are not familiar with using derivatives or the collateral issues that come with them, said Chris Sullivan, managing director and co-head of fixed income for Goldman Sachs Asset Management.

“Those pension funds often approach LDI providers with the vision of using an overlay strategy, then decide to make direct investments in fixed income instead after they find out how much collateral could cost the plan.”

SEI, however, seems to disagree.  P&I reports that nearly all of its clients use swaps to match assets and liabilities.  In fact, Jim Morris, senior vice president, global institutional solutions at SEI tells P&I:

“Of course a fixed income manager is going to want clients in an account where they can charge a fee…”

There’s little question that portable alpha and liability-driven investing (LDI) have captured the attention of the world’s pensions over the past 5 years.  But while pension funds are attracted to the results of such strategies, they can be turned off by their complexity (related posting).  As they say about sausages (and democracy), “Tastes great, but you sure don’t want to see how it’s made!”

Now Pensions & Investments reports that at least one LDI provider, ING, has offered to make the entire sausage itself.  All the pension has to do is pull up a chair and enjoy those tasty links with their scrambled eggs.

This development was inevitable. It seems to be the natural evolutionary path of various business services industries.  Services firms who begin life as consultants gradually morph into full-fledged suppliers of core business functions.   For example, in the 1990’s, it gradually dawned on the consulting industry that if it was so good at creating efficiencies, why should it not just assume responsibility for entire business processes on a contingency fee basis.  That way, they could profit from their own ideas, rather than simply provide them by the hour.  I recall my own employer, a Big 5 firm, pitching the US Government on the operation of entire military and government installations.

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