The Case for Liability-Driven Investing Strategies Now

Current market conditions—elevated corporate discount rates, strong yields on fixed income, and relatively high funded ratios—have presented a timely opportunity for pension plans to adopt a liability-driven investment (LDI) approach. Segall Bryant & Hamill (SBH) has demonstrated expertise in effectively managing customized LDI strategies with an emphasis on downside protection and investments in high-quality, underfollowed fixed income securities.

What is LDI?

LDI is the exercise of matching the interest rate sensitivity of pension plan assets to that of the liabilities to reduce tracking error between the two. It is primarily a risk management tool, which means it is different than a traditional “total return” fixed income strategy. LDI strategies are designed to help pension plans achieve their goals by mitigating risk, decreasing volatility, and maintaining funding gains. 

LDI strategies, however, can be undermined by unforeseen risks. Often, the universe of securities used by actuaries to discount the liabilities may be too concentrated and skewed toward illiquid, esoteric issuers and credit profiles that plan sponsors and/or LDI managers may want to avoid. 

An LDI strategy can be implemented at differing levels of commitment, ranging from allocating only a portion of plan assets to the strategy to a full commitment of the portfolio to LDI, or to a full immunization of all future cash flows of a fully funded plan.

Why is LDI Important?

The relationship between pension assets and liabilities has broad-ranging impacts for plan sponsors. When the risk profiles of the assets and liabilities are not matched, movements in interest rates or market conditions can create unwanted volatility. Further, movements in the asset and liability profiles can impact cash flows as well as financial statements and results, so we recommend that this relationship be a key focus area for treasurers, chief financial officers, and chief executive officers, among others.

How Does the Strategy Get Started?

The first step in matching assets to liabilities is to determine a benchmark of securities that matches the profile of the pension liabilities. These benchmarks can be very specific—focused on a precise maturity, duration, or credit quality—or can be broad market indices comprising various long-duration assets.

Constructing an appropriate benchmark requires an understanding of the plan sponsor’s liability cash flow profile, plan discount rate and underlying characteristics, and then establishing appropriate limitations that align with a client’s risk appetite. At SBH, we work closely with clients, consultants, and clients’ actuaries to develop customized LDI solutions that are aligned with each client’s specific objectives.

SBH’s LDI Experience

Long Tenure Managing LDI Strategies
Actively managing bond portfolios since 1994 and long duration and LDI fixed income since 2010.

Rigorous Fundamental Credit Research
Proprietary fundamental research conducted by fixed income specialists with 25 years average experience for portfolio managers (as of 12/31/23).

Customized Portfolio Construction
Portfolios customized to client needs and built on a bottom-up, bond-by-bond, basis.

Why Now?

Recent market developments have allowed defined benefit plans to attain attractive levels of funding (see chart below) while corporate bond yields are higher than we have seen in quite some time. For example, yields on highly rated long corporates are around 5.1% (as of 1/31/24) and many fund sponsors are enjoying funded statuses of over 100%. In addition, the average pension plan still only has about a 50% allocation to fixed income.1 Together, we believe these factors make it an opportune time to lock in funded status gains.

Defined Benefit Plans: Time to Lock in Funded Status Gains?

Data as of 1/31/24. Source: Bloomberg

Solutions at SBH

There are many factors to consider before implementing LDI, including risk tolerance, company constraints, funded status, plan status, and the market environment. Further, regulatory rules, accounting treatment, and actuarial impacts surrounding LDI can be complex, and a thoughtful approach is necessary to have the strategy customized for each plan’s circumstances and approach to risk. The long-tenured team at SBH uses a consistent approach to LDI designed to perform well in all periods, with an emphasis on downside protection and cash-paying corporate bonds (to avoid the pitfalls of derivative strategies). We consider these factors and then apply our philosophy of investing in high-quality, underfollowed securities through a consistent research process aimed at constructing optimal investment portfolios.

To learn more about the SBH approach to LDI and how it might benefit your firm, contact us at (800) 836-4265 or [email protected].

1 Source: Milliman 2023 Corporate Pension Funding Study, April 2023.

Published February 2024

All opinions expressed in this material are solely the opinions of Segall Bryant & Hamill. You should not treat any opinion expressed as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the manager’s opinions. The opinions expressed are based upon information the manager considers reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this material does not constitute financial, legal, tax or other professional advice and is not intended as a substitute for consultation with a qualified professional. The manager’s statements and opinions are subject to change without notice, and Segall Bryant & Hamill is not under any obligation to update or correct any information provided in this material.

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