Pension Solutions’ Insights

330657 LGIMA_LDI implementation wo constraints of market bencharks reprint.indd 1 4/17/13 6:25 AM 330657 LGIMA_LDI implementation wo constraints of market bencharks reprint.indd 2 Executive Summary Our LDI clients continue to move down their de-risking glidepaths. As they move down the de-risking path, they are increasingly focused on controlling risk and understanding performance versus specific liabilities as opposed to indirectly managing risk via market benchmarks. We refer to this type of LDI implementation, where risk is managed and performance is measured versus explicit liability benchmarks, as Level 2 LDI. We find that freeing LDI implementation from the constraints of market benchmarks and utilizing explicit liability benchmarks brings with it significant risk management and governance benefits. With respect to risk management, having the LDI manager manage risk versus an explicit liability benchmark facilitates day-today risk management of assets versus liabilities as opposed to managing risk versus a blend of market benchmarks. This overcomes two shortcomings we see in managing risk versus a blend of market benchmarks (1) the uncompensated risk stemming from a particular blend of market benchmarks becoming suboptimal over time relative to the desired liability-relative exposures and (2) an inefficient curve match between assets and liabilities. Importantly, using a blend of market benchmarks results in the client owning the risk associated with these two shortcomings. Assigning the LDI manager an explicit liability benchmark means that the LDI manager owns these uncompensated risks and, as a result, will reduce these risks. We also find that for LDI adopters, plan governance is significantly improved by measuring performance versus explicit liability benchmarks. This allows our clients to understand how the LDI manager is performing versus their liability benchmark. Our clients find this much more useful than a report that details how an LDI manager did versus a blend of market benchmarks but lacks detail or accountability for how the blend of market benchmarks did relative to the liability. To this end, we present an LDI performance framework that controls for the uninvestable nature of liability benchmarks and allows our clients to understand the impact of the investment decisions the LDI manager has made. Lastly, we present our funded status attribution framework which provides important feedback to the client in terms of how well the LDI solution is working to control the key sources of funded status volatility. Introduction Over the past several years our work with Liability Driven Investing (LDI) clients has evolved …