Fixed Income

The immunization illusion in LDI

Liability investors often tell us that they spend the vast majority of their time focused on the growth component of their portfolio and very little time on the fixed income element. There appears to be a mindset of ‘set it and forget it’ on the portion of assets that is often by far the largest dollar amount.

11/13/2017

Andrew Chorlton

Andrew Chorlton

Head of US Multi-Sector Fixed Income

Jeffrey Connor

Jeffrey Connor

Senior Investment Risk Strategist

Liability investors often tell us that they spend the vast majority of their time focused on the growth component of their portfolio and very little time on the fixed income element. There appears to be a mindset of ‘set it and forget it’ on the portion of assets that is often by far the largest dollar amount. However, there are important reasons to verify how much of a hedge your hedge assets are actually providing. Put simply, we believe when you recognize the limitations on the precision of your hedging assets you will free yourself to embrace alpha opportunities for those assets and have all your assets working to improve funded status.

The rationale behind our research

Broadly speaking, the goal of a bond portfolio within an LDI program is at the very least to match the movement in the liabilities. Many LDI bond programs have thus been modeled on the UK approach, namely buy the asset that most closely mirrors the discount rate of the liabilities. In the UK this is fairly straightforward, with a discount rate of government bond yields, a portfolio of government bonds (or Gilts) is a simple match. A US Defined Benefit pension plan, however, is discounted using a high quality corporate bond rate, and investment programs are designed using a proxy bond portfolio made up of corporate bonds. Unfortunately, the discount rate is not an investable security and so the proxy portfolio creates inefficiency, the impact of which is often either misunderstood or understated.

This prompted our research in seeking to improve the liability hedging component within a US LDI program, since unfunded liabilities can significantly drag on a typical pension plan; even one that is at or near fully funded. Furthermore the liability component is often assumed to be the most easily hedged or “immunized”. However, we would challenge this view for a number of reasons.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.