Things To Ask Your LDI Manager

Source: Things To Ask Your LDI Manager

LDI is the acronym for Liability Driven Investment. It is better explained as Asset Liability Management which we promote at Ryan ALM. It has developed into two main strategies either to fund liabilities through cash flow matching or to immunize the interest rate sensitivity of liabilities through duration matching. Below is a short list of questions we urge plan sponsors and pension consultants to ask to any LDI prospective asset manager. Please call us for more LDI guidance.

Are you a Duration Matching (DM) or a Cash Flow Matching (CFM)manager?

If Duration Matching… ask these questions:

1. What is the source of your liability duration calculation? (Actuaries usually do not provide such calculation)

2. What is the discount rate(s) you use for your duration calculation? Is it a single rate? (ASC 715 is best for accurate market value calculation which is a AA corporate yield curve)

3. Are you using an average duration, key rates, or matches along the yield curve?

4. Do you match total liabilities including those past 30 years?

5. How often do you rebalance?

6. Do you make or fund the liability payments (benefits + expenses)? (Most DM managers are not term structure matched so not aligned to pay liabilities)

If Cash Flow Matching… ask these questions:

1. What liabilities are you funding? Gross or Net?

2. How are you funding the annual actuarial projected liability cash flows?

3. How much of a funding cost savings do you expect to realize? (Major CFM benefit is the funding cost savings: FV of liabilities – PV of CFM = about 2% per year which is achieved as soon as the CFM portfolio is built)

4. How do you fund liabilities past 30 years?

5. How many years of experience do you have with CFM? (CFM may be the oldest LDI strategy starting with Dedication in the 1970s)

As our name implies, Ryan ALM Advisers is dedicated to Asset Liability Management specializing in Cash Flow Matching… our only LDI product. We strongly feel that CFM best fits any liability objective including Pensions, OPEB, Lotteries, NDA, and E&F. Our team has over 168 years of experience dating back to the 1970s with Dedication models. Our CFM product is called the Liability Beta Portfolio™ which will fully fund monthly net liabilities at a funding cost savings of about 2% per year (40% on 1-20 years of liabilities). We can fully fund and CFM up to 30 years with certainty. This term structure monthly cash flow matching approach also provides the best duration matching as each monthly liability payment is fully funded and duration matched. After 30 years we are compatible and synergistic with any derivative strategy a plan sponsor may want to use.

Pension Confusion - The Problem with Averages

Source: Pension Confusion - The Problem with Averages

Pension Confusion:

The Problem with Averages

Most pension have assets managed to generic market index benchmarks and/or liabilities. In both cases, the focus of these assets is to match or beat some average (i.e., duration, total return, YTM). Unfortunately, few understand how these averages can be misleading if not erroneous.

Liabilities (Duration Matching)

Duration matching is a common LDI strategy for pensions where the plan sponsor looks to immunize their bond portfolio versus the interest rate sensitivity of the liabilities they are funding. To achieve this interest rate immunization, the strategy is to match the average duration of the liabilities. There are at least four problems here:

1. The actuary does not provide the average duration of projected benefits.

2. The actuarial report usually comes out annually… months after the fiscal year. Duration is a present value calculation that changes with interest rates and time, both of which change daily.

3. Assets do not fund gross projected benefits. They fund net benefits after contributions. This net liability is not calculated by the actuary which can be much different than the gross liability in dollars and duration especially for Corporate and Public pension plans that have a high contribution rate. Pension assets need to know what they are funding. The economic reality is… assets are funding net liabilities after contributions!
   

4. Duration is a present value calculation based on a discount rate yield curve. ASC 715 is the most prominent and acceptable for corporate and multiemployer pension plans. Moreover, Moody’s has adopted ASC 715 discount rates to assess municipal credits instead of the ROA discount rate commonly used under GASB accounting. FASB requires that this ASC 715 discount rate yield curve be converted to a single rate average discount rate. The duration of this single discount rate is certainly different than the average of a multiple discount rate yield curve. In the sample liability term structure shown on the next page priced with ASC 715 discount rates, we calculate:

	ASC 715 Yield Curve	Single Rate	Difference
Average Yield	2.29%	2.72%	0.43%
Duration	13.84 years	14.34 years	0.50 years

Note: For an accurate immunization, you need to match the duration of the ASC 715 yield curve (all liabilities) not the single rate average duration.

Solution: $ Duration Matching with Modified Duration

Maturity is an indicator of interest rate risk because longer maturity bonds move more in price than shorter maturity bonds given a change in yield. However, maturity is not a good measure of interest rate risk because maturity only considers the timing of the final principal cash flow at maturity and ignores the sizes and timing of all the other cash flows leading up to maturity.

The present value or price volatility of pension liabilities behaves just like bonds. A pension liability schedule is a term structure or yield curve of ASC 715 rates. Therefore, the interest rate risk in a pension liabilities schedule (actuarial projected benefits) can be matched with a portfolio of bonds.

A better measure for interest rate risk in the form of price sensitivity is called Modified Duration. Modified Duration considers all the bonds cash flows and is the weighted average time to receipt of all the cash flows, with the weights being the present values of the cash flows divided by a factor of (1+Y) where Y is the annual yield to maturity of the bond.

Modified Duration represents the percentage price change in market value in response to a change in the asset or liability yield. By weighting modified duration by the market value of the holding, that is, by multiplying the market value of the position by its modified duration, we get dollar-weighted duration. This dollar-weighted duration is known as Dollar Duration and represents the actual dollar change in market value for a bond given a change in its yield. Dollar duration is typically expressed in the dollar value change per one basis point change in yield (DV01).

The major advantages of using dollar duration are that it is additive and better suited for asset liability management. Dollar duration extends easily from individual securities to entire portfolios. The dollar duration of a portfolio is simply the sum of the dollar durations of all the individual holdings. The dollar duration of a bond portfolio can be matched to the dollar duration of pension liabilities. Bond durations cap out around 20-years so for liabilities with durations longer than 20-years it is not possible to match duration but… it is possible to match the Dollar duration of liabilities with durations longer than 20-years. Therefore, Dollar duration is very useful in asset liability management for liability driven investors such as defined benefit pension plans.

Ryan ALM uses dollar duration matching to help reduce pension volatility as defined as the dollar value difference in interest rate sensitivity between the present value of assets and liabilities. Ryan ALM starts by creating a Custom Liability Index (CLI) for each pension client. The Custom Liability Index is derived from the unique liabilities cash flow schedule provided by the plan actuary. The CLI measures and monitors the change in present value for the liabilities given a change in ASC 715 discount rates and is the proper benchmark for a plan sponsor and their liability driven investor(s).

Once we have determined the interest rate risk in the liabilities, the next step is to ensure that the bond portfolio has the same amount of interest rate risk as liabilities in order to reduce volatility between the present value of assets and liabilities. Ryan ALM builds a bond portfolio called the Liability Beta Portfolio (LBP) that matches the cash flows of the bonds to the liability cash flows (benefit payments). Since dollar duration is additive, we can set the dollar duration of the bond portfolio equal to the dollar duration of liabilities. Ryan ALM believes that cash flow matching liabilities with bond cash flows along with the use of dollar duration is a lower cost and lower volatility approach to pension asset liability management. It is certainly more accurate than traditional duration matching to immunize interest rate sensitivity.

Pension Alert: Secure Funded Status!

Source: Pension Alert: Secure Funded Status!

Private Pension Alert: Secure Funded Status!

The pension objective is to secure benefits in a cost-efficient manner!

Many private pension plans are in the best funded status since 1999. It should be a high priority to secure this funded status NOW if not enhance it.

Secure Benefits and Reduce Funding Costs

There are basically only two ways to secure pension benefits: insurance annuities and defeasement (through cash flow matching benefit payments). Ryan ALM has been a pension watchdog and written many articles on the benefits of cash flow matching. Insurance buyout annuities (IBA) are expensive, but corporations are purchasing IBAs in record amounts to get rid of the high and rising PBGC premiums caused by the MAP 21 legislation of July 6, 2012 and to avoid longevity risk. However, corporations would be wise to do a cost analysis of the IBA versus a cash flow matching defeasance. The typical IBA prices Retired Lives (liabilities) at a discount rate of ASC 715 (AA corporate zero-coupon yield curve) plus a 3% to 4% premium. According to our calculations, a defeasance strategy (cash flow matching) using investment grade corporates would provide a cost savings of about 30% versus IBA, which is a very significant cost savings and should be reviewed. Such cost savings are immediate while the IBA savings of eliminating PBGC premiums is in the future.

Cash flow matching (using the Ryan ALM Liability Beta Portfolio™) is a cost optimization process where we go through numerous iterations to find the optimal cost savings that will fund each and every monthly Retired Lives benefit payment. Since liabilities are priced like bonds (ASC 715 discount rates) they behave like bonds. As a result, bonds become the proper assets to match and fund liabilities. Bond math tells us that the longer the maturity and the higher the yield… the lower the cost. Our LBP model skews the portfolio weights to longer maturities such that a 30-year coupon bond will partially fund 29 years of benefits through interest income. The same is true for a 29-year, 28-year, 27-year bond, etc. plus principal cash flow at maturities adds even more cash flow. Cash flow matching reduces funding risk because the bond cash flows are certain and the bonds may be held to maturity. Moreover, cash flow matching is the matching and funding of future values which do not change with changes in interest rates.

Reduce and Stabilize Contribution Costs

The LBP will match each and every monthly benefit payment in the liability schedule it is funding (Retired Lives). This will greatly reduce funded status volatility which will help stabilize contribution costs. The LBP is comprised of investment grade bonds skewed to longer maturities and A/BBB credits, so it will out yield liabilities priced as AA corporates (ASC 715 discount rates) by 50 – 100+ bps. Importantly, this extra yield creates an excess return (Alpha), which enhances the funded status, reduces contribution costs and could reduce the PBGC variable premium.

Only cash flow matching (defeasance) can secure benefits and reduce funding costs with certainty! By matching liabilities (benefit payments) it reduces risk accordingly.

Our LBP has numerous benefits that best achieve the true pension objective:

Cash flow matching the liability benefit payment schedule (Retired Lives) at the lowest cost is the ideal way to manage assets for a pension plan. Since Retired Lives are the most certain and most important (most tenured employees) liabilities, cash flow matching is a perfect fit given the certainty of the bond cash flows. Since the pension objective is a cost focus, cash flow matching would produce the optimal cost savings. We urge corporations to do a cost analysis before they buy an IBA! Even if an IBA is the future goal then the LBP would provide the perfect pension risk transfer of assets to an IBA.

Problem: Immunization (Duration Matching)

Duration matching is a strategy that attempts to reduce financial statement volatility while cash flow matching is a strategy for reducing funding volatility. Another difference is that duration is an ever-changing number so with duration matching the manager must continually rebalance for duration drift, while cash flow matching has the advantage that bond cash flows do not change. When we use duration matching to hedge financial statement volatility, we make assumptions that the yield levels of the liability hedging vehicle will move in parallel with liability yields. The fact is yields for different credits, and maturities do not all move in parallel. To facilitate benefits funding management ALM should focus on the liability yield curve or term structure which is exactly what the Ryan ALM custom liabilities cash flow matching and $ duration matching portfolios do in the most cost-efficient manner.

Traditional duration matching has definite liability cash flow mismatches and cost inefficiencies. Since the longest duration coupon bonds are around 19-years today, duration matching is forced to use Treasury zero-coupon bonds (STRIPS) to fund any liability past 19-years. Since Treasuries are the lowest yielding bonds, they are the highest cost bonds to fund and match liabilities. Moreover, duration is a present value (PV) calculation that is very interest rate sensitive. Duration matching is focused on matching liability % growth rates and not on matching and funding benefit payments (future values) and dollar growth rates.

Solution: Dollar Duration Matching (DDM)

DDM matches the dollar value change per basis point change in yield for assets with the dollar value change per basis point change in yield for liabilities. When the dollar duration of assets is matched to the dollar duration of liabilities for every year in the term structure of liabilities, then DDM is in its most precise form. That would be the equivalent of 30 Key Rate durations… one at every point along the liabilities yield cure or benefit payment schedule. The Ryan ALM DDM approach offers several value-added differences:

1. Actuarial Projections - We use the actuarial projected benefits of our clients and not a generic bond index benchmark.

2. Modified durations - to be an effective price sensitivity measurement, duration must be modified. Modified Duration measures the percent change in market value or present value for future value cash flows given a 100-basis point movement in yield.

The Ryan ALM DDM approach greatly improves the accuracy of Key Rate duration matching by matching the dollar value changes in liabilities with the dollar value changes in assets across the term structure and yield curve for liabilities. The liabilities are measured and monitored by using a Custom Liability Index (CLI) to more precisely calculate the dollar value (PV) movement in assets versus liabilities given any movement in interest rates.