Liability-driven investing: Benchmarking by asset class

Liability-driven investing (LDI) has grown in prominence in recent decades and is now a core component of investment strategies for defined benefit pension plans.¹ The investment strategy’s growth in popularity has resulted from its effectiveness in both hedging interest rate risk and reducing pension funded status volatility. Pension plan assets and liabilities sit on corporate balance sheets and drive cash contribution requirements, accounting expense and some administrative expenses. As a result, many plan sponsors are interested in reducing funded status volatility for their plans, and LDI can be an effective tool to help meet that objective.

Investment grade² fixed income is typically the primary asset class utilized in LDI portfolios. Bond prices are inversely related to market interest rates. When interest rates fall, bond prices rise. Likewise, pension liabilities are also inversely related to market interest rates, since the determination of a current pension plan liability measure requires discounting projected benefit payments to the present using discount rates. Pension liabilities are typically discounted using the yields available on high-quality investment grade bonds, and those same bonds are commonly used to hedge the liabilities. With expected benefit payments often going decades into the future, pension liabilities tend to have long durations and are therefore quite sensitive to interest rates. LDI portfolios have traditionally been implemented by investing in fixed income securities that closely resemble the characteristics of the plan liability. The desired outcome is that the LDI assets and plan liability move together as market interest rates change.

LDI can help mitigate the interest rate risk associated with a plan liability, but plan sponsors often have additional goals. Underfunded or accruing plans, in particular, require greater asset growth to keep pace with the liability. Traditionally, equities and other return-seeking assets have been used to target investment growth independently of a plan’s LDI portfolio. More recently though, some plan sponsors and investment managers have begun incorporating additional asset classes in LDI portfolios—with the goal of providing both growth and liability-hedging characteristics simultaneously. Some of these asset classes include real estate, high yield debt, commodities and private credit.

For plan sponsors focused on minimizing funded status volatility by implementing the tightest liability hedge possible, there’s no substitute for investment grade debt. Given its common usage, it’s classified as a traditional LDI asset class for the purposes of this analysis. Other plan sponsors might be willing to accept increased funded status volatility in exchange for potential surplus returns. For those under these circumstances, two other asset classes were identified that could potentially serve as LDI-growth hybrids: real estate and high yield debt. For ease of labeling, LDI-growth hybrids are designated as LDI hybrid asset classes.

The analysis shows that these LDI hybrids have historically displayed some correlation with liability index proxies and exhibited surplus return potential. However, in certain market environments, hedging benefits may evaporate—negatively impacting a plan’s funded status. Plan sponsors intending to utilize LDI hybrids within their plans’ LDI portfolios must ensure that they understand the associated risks and the potential for greater funded status variability than expected. Other asset classes considered, including equities and commodities, demonstrated limited hedging benefits and were classified as non-LDI assets. It should be noted that private credit was not explicitly analyzed in this exploration since sufficient historical index return data is unavailable. However, properly structured private credit arrangements could potentially play a role in LDI portfolios. Additionally, hedge funds weren’t analyzed in depth for the purposes of this analysis since there are a wide variety of hedge fund types and strategies—making any rendered LDI judgement of little use for a qualified defined benefit pension plan.

This paper discusses the following:

• What is a pension liability?
• What is an LDI hybrid?
• Asset class index performance data: initial observations
• Analysis by asset class: fixed income, equities, commodities, real estate, high yield debt
• Key takeaways

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Read our paper to get a deeper dive into trends, strategies and risk management practices in the LDI landscape.