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Institutional Investment - July 02, 2014

Dynamic Liability-Driven Investing Strategies: The Emergence of a New Investment Paradigm for Pension Funds?

A number of profound changes have taken place, which have collectively led to the emergence of a new investment paradigm for pension funds. The standard paradigm for pension fund investments, which used to be firmly grounded around one overarching foundational concept of the policy portfolio, is slowly but surely being replaced by a new, more modern, investment paradigm known as the dynamic liability-driven investing (DLDI) paradigm. This new paradigm has two main defining characteristics: on the one hand, a focus on the management of portfolio risk relative to the liabilities, as opposed to absolute risk; and on the other hand, a focus on dynamically time-varying allocation within and across the risky and the safe building blocks.

The purpose of this survey is to assess the views of pension funds and sponsor companies with respect to this new investing paradigm and their desire to integrate this approach into their processes. Overall, there are a few key insights which we obtain from this survey.

First, an overwhelmingly large fraction of the respondents, in fact almost 80% of them, are now fully aware of the LDI paradigm. Secondly, slightly more than 50% of the respondents explicitly measure liability risk through a probability of a shortfall or the magnitude of this shortfall. Thirdly, roughly 50% of them are not only aware of the importance of measuring and managing liability risk, but have effectively adopted the LDI approach, which encompasses an explicit focus on liability hedging that is achieved through a dedicated liability-hedging portfolio, as opposed to seeking to diversify away liability risk within some well-balanced policy portfolio. In a large majority of the cases, such a liability-hedging portfolio is dominated by fixed-income instruments, sovereign bonds, corporate bonds and interest rate derivatives, which reflects the recognition by pension fund managers that liability risk is strongly dominated by interest rate risks, even for inflation-linked liabilities. The fourth key insight we learn from this survey is that risk allocation, a novel approach to diversification within the performance-seeking portfolio, has already been adopted by more than 35% of the respondents to the survey.

While these results suggest a strong degree of adoption of modern risk management and ALM techniques by pension funds, a number of sources of concern also exist. First of all, we find that about 50% of the pension fund respondents are hedging their liabilities while the rest of the respondents are still sitting on the sidelines. Moreover, duration matching is only perceived as a desirable or a feasible target by about 60% of the respondents who express a focus on liability hedging, which implies that effective liability hedging is not always achieved, not even by those who express an interest in this objective.

Another key insight from the survey is that only about 40% implement a DLDI process, which requires periodic revisions of the portfolio policy. We also learn that half of the respondents who do use DLDI strategies use derivatives in implementation. In this context, we find the presence of a strong geographical factor, with Northern-European countries such as Denmark, Germany and the Netherlands showing a substantially higher adoption rate compared to other countries represented in the survey. The desire to adapt the portfolio composition to changes in market conditions (revisions of strategic asset allocation) is perceived as the main motivation for the largest percentage of respondents (33.33%), with the desire to add value through active forecasts (tactical asset allocation decisions) and the desire to reduce risk-taking when approaching floor asset levels (risk-controlled investing) also being major motivations (each with slightly more than 25% of the respondents).

Another source of concern is that most respondents do not translate the minimum funding requirements imposed by the regulation into floors on asset value: more than half of participants recognise that they operate under such constraints, but hardly a fifth of them impose bounds.

The last insight from this survey is that a majority of the respondents are aware of the presence of conflicts of interest between various stakeholders, while slightly less than half of the respondents have already made some steps towards an integrated approach to pension fund asset-liability management if only through attempts to adopt some form of hedging mechanism against sponsor risk.

Overall, the findings in this survey highlight an ever increasing awareness by market participants that pension fund investment management is very much related to liability risk management. While a number of implementation constraints exist that do not facilitate the adoption by pension fund managers of a modern investment framework relying upon an effective use of the three forms of risk management (diversification, hedging and insurance), and which explain why a number of pension funds are still sitting on the sidelines, the understanding of the potential benefits to be expected from DLDI strategies is clearly on the rise. In particular, risk management is increasingly perceived as being the approach allowing investors to maximise the probability of achieving their long-term objectives while respecting the short-term constraints they face. This is somewhat reminiscent of another prophecy from the late Peter Bernstein who, beyond the (premature) announcement of the death of the policy portfolio, made the following illuminating comments about the central role of dynamic risk management in investment management decisions (Bernstein (1996)): "The word risk derives from the Latin risicare, which means to dare. In this sense, risk is a choice rather than a fate. (…) The actions we dare to take, which depends on how free we are to make choices, are what the story of risk is all about."

This research was produced as part of the "Asset-Liability Management and Institutional Investment Management" research chair at EDHEC-Risk Institute, in partnership with BNP Paribas Investment Partners.