LGIMA’s quarterly “Pension Fiscal Fitness Monitor” measures the historical market-related funding ratio performance of the traditional “60/40” investment strategy (60% global equity and 40% aggregate bond investment strategy) and three different approaches to liability driven investing (LDI) implementation.
For each of the three approaches, LGIMA analyzes how funding ratio performance would have changed for three different levels of equity exposure—60%, 40% and 20% equities. The three approaches are designated as Long Credit LDI (100% of fixed income allocated to long-duration credit), Level 1 LDI (a custom blend of market benchmarks designed within a total portfolio context) and Level 2 LDI (a custom liability benchmark and derivative overlay designed within a total portfolio context).
According to the Pension Fiscal Fitness Monitor, an analysis of funding ratio ratios for U.S. pension plans during the second quarter showed that plans with low allocation to risk assets underperformed as Treasury markets slumped. The funding ratios of the Long Credit LDI portfolios increased 2% to 4%. Funding ratios for Level 1 LDI portfolios were all in a range of 2% to 4%, slightly underperforming the traditional approach due to higher hedge ratios. Funding ratios for Level 2 LDI portfolios increased 1% to 2%, slightly underperforming the traditional approach and the Level 1 approach due to higher hedge ratios. Liabilities decreased 7% as the discount rates increased significantly during the quarter.
In terms of funding ratio volatility and Level 1 portfolios, the Monitor found that:
- Funding ratio volatility has emerged as an important metric for measuring plans that have adopted an LDI approach;
- The Level 1 approach involves setting the benchmark of the liability hedging assets (LHA) within a total portfolio context using a custom blend of credit and Treasury market benchmarks;
- When there is an exposure to equities, there are significant risk management benefits to holding Treasuries and using them to either maximize duration or more precisely manage interest rate risk;
- The benefits of this total portfolio context can be seen by comparing, for each level of equity exposure, the historical volatility between the long credit and Level 1 approaches; and
- There have been minimal risk reduction benefits by moving from the traditional portfolios to long credit when holding 60% equities.
The Monitor also found that with regard to funding ratio volatility and Level 2 portfolios, a Level 2 approach involves managing the LHA against a customized liability benchmark with explicit interest rate and credit spread hedge ratio targets; there is a substantial reduction in volatility moving from a Level 1 to a Level 2 approach; and the additional fall in volatility (versus Level 1) comes from better curve matching and daily interest rate hedge ratio management.