PLANSPONSOR - February/March 2021 - 8

UPFRONT
Do Traditional LDI Strategies Still Work?
MICHAEL CLARK, managing director
and consulting actuary with River and
Mercantile, says 2020 was interesting in
terms of how defined benefit (DB) plan
sponsors applied liability-driven investment
(LDI) glide paths in volatile markets.
" Most plans probably ended the year
where they started in terms of funded
status, " Clark says, " but there were many
ups and down in between. Those that rode
the course ended the year slightly worse off.
After the market crash in the first quarter,
plans that put more money into growth
assets probably [came out] a little ahead of
those that stuck with the status quo. "
Most DB plan sponsors are seeking a
portfolio strategy that prevents them from
going backward in funded status, Clark
says. There is a trade-off between liability
hedging and seeking returns.
Broadly speaking, DB plan sponsors
need to consider restructuring their LDI
portfolios, says Kevin McLaughlin, head of
liability risk management, North America,
at Insight Investment. Sponsors should
focus on two things, he says: increasing
the hedge ratio in times of extreme volatility
to maintain enough liquidity, and
increasing returns to fill funding gaps.
Sponsors need a hedge for liabilities,
McLaughlin says. " If they don't hedge for
interest rates and get it wrong, even small
movements in interest rates will mean the
return needed from growth assets will
increase exponentially. "
Hedging can also counteract volatility,
he adds. " We advise clients to try to
keep problems solvable through investment
returns. If interest rates decline,
they will need assets to fill the funding
gap. " Underfunded plans especially could
benefit from hedging, he says, because
" we're not sure we've seen the bottom for
interest rates, and due to market volatility. "
LDI Portfolio Components
Going beyond the traditional glide path,
DB plans can use derivatives to decouple
8 PLANSPONSOR.COM February - March 2021 Art by Sarah Mazzetti
risk from growth, Clark suggests. " With
derivatives, sponsors can decide how much
interest rate risk to assume or hedge and
how much market risk to assume or not,
and they can do that in a controlled way. "
One method is to invest all of the
portfolio's assets in liability-matching
vehicles, then access equity synthetically
through puts, calls and options strategies,
Clark says. " This offers an optimized
interest rate hedge and an equity exposure
that plan sponsors are comfortable with.
Sponsors get some downside protection,
a range of returns they like and a bigger
engine than what they have with just the
physical assets in the portfolio. "
He recommends derivatives swap
options-aka derivatives swaptions-for
the liability-matching side of LDI portfolios.
According to the Corporate Finance
Institute, a swaption is an option contract
that grants its holder the right, but not the
obligation, to enter into a predetermined
swap contract. In return for the right, the
http://www.PLANSPONSOR.COM
PLANSPONSOR - February/March 2021

Table of Contents for the Digital Edition of PLANSPONSOR - February/March 2021
