Exploring LDL

In recent years, as more pension plans have advanced along their de-risking paths, there's been heightened interest in asset classes residing in the ambiguous zone between growth and hedging categories. These assets often offer the potential for higher returns, enhanced diversification, and various degrees of liability hedging.

Over the past two decades, pension plan sponsors' approaches to liability-driven investing (LDI) have evolved significantly. Changes in accounting practices led to a more mark-to-market approach, and later, the adoption of glidepaths steered many sponsors towards a steady de-risking of their plans.

A typical glidepath balances between growth-focused assets (like equities) and liability hedging assets (mainly investment-grade fixed income). While this is effective for maintaining de-risking discipline and pursuing long-term goals, it may result in overlooking beneficial asset classes that don't fit neatly into the conventional "growth vs. hedging" framework.

This article explores these "liability-friendly alternatives" and how plan sponsors are incorporating them into portfolios to improve long-term outcomes.

Defining a Hedging Asset

Traditionally, liability hedging assets are those closely matching the liabilities' sensitivities (like interest rate and credit spread). Most pension plans have relied heavily on long-duration treasuries and investment-grade corporate bonds. However, these alone may not meet the return or diversification needs of a plan sponsor. In contrast, the growth bucket has diversified over time, including allocations to alternative asset classes.

We advocate for plan sponsors to broaden their toolkit to include assets that share some risk exposures with liabilities, particularly in duration and/or credit spreads. The position of each asset on the growth vs. hedging scale varies depending on the investment's nature and the asset manager's strategy.

Pension liabilities are particularly susceptible to shifts in rates and credit spreads.

An Evolution, Not a Revolution

Pension plan liabilities are largely unaffected by downgrades or defaults in the discount rate used for valuation. This poses a challenge for plan sponsors in constructing fixed income portfolios that match the liabilities and maintain funded status. Traditionally, sponsors have explored lower-quality options to boost potential returns and diversification for robust hedging portfolios. However, other asset classes can offer additional yield without compromising quality.