Executive summary:
- Liability-driven investing is entering a new phase, where the focus is shifting from simply hedging interest-rate risk to refining liability hedging strategies and managing more nuanced risks.
- Plans that have already adopted LDI are now fine-tuning their approaches to hedge liabilities more efficiently across the entire yield curve, rather than focusing solely on long-duration fixed income. Plan sponsors are also paying closer attention to the credit spread hedge.
- LDI remains crucial to protecting a plan's funded status as it approaches full funding. For plans that have achieved full funding or are frozen, LDI also plays a vital role in maintaining long-term stability by locking in the current funded position.
- With rates currently high, we believe now is an opportune time for plan sponsors to consider improving the liability hedge with LDI.
We recently sat down with Justin Owens, our senior director and co-head of strategic asset allocation, to discuss the next phase of liability-driven investing (LDI) and the key trends driving this evolution. Below is a recap of our conversation.
LDI has been around for a while, but what does the next phase look like for pension plans?
We’re entering a new phase of LDI (liability-driven investing), where it’s not just about extending fixed income duration but about optimizing those allocations in response to a broader range of risks. Many plans have reached high funding levels, so the focus is shifting from simply hedging interest rate risk to refining liability hedging strategies and managing more nuanced risks. The future of LDI involves more dynamic, diversified approaches that can include non-traditional assets and greater sophistication in liability measurement.
What are the key trends driving this evolution in LDI?
The biggest trend is the refining of LDI strategies. Plans that have already adopted LDI are now fine-tuning their approaches to hedge liabilities more efficiently across the entire yield curve, rather than focusing solely on long-duration fixed income. An LDI overlay can be an excellent tool in fine-tuning the hedge. Another key trend is paying closer attention to the credit spread hedge. A variety of asset classes can help hedge this risk, including asset classes not necessarily considered in the past from an LDI perspective.
For example, we’ve seen more interest in private fixed income assets like private placements and investment-grade securitized fixed income. While not perfect matches to the liabilities, they can help to mitigate risk in stressed credit environments, diversify credit issuer exposure, and also potentially offer attractive excess returns.
With many plans now close to fully funded, is there still a role for LDI?
Absolutely. As pension plans approach full funding, LDI becomes even more critical—not just to hedge volatility but to protect that funded status. For fully funded and frozen plans, LDI plays a key role in maintaining long-term stability by locking in the current funded position. The portfolio’s focus is no longer on overcoming short-term deficits but rather ensuring the plan can stay fully funded without excessive risk-taking in equities. This transition calls for a more strategic allocation to LDI, ensuring that the most significant risks are managed with the right mix of assets.
How is the concept of glidepaths evolving in the context of LDI?
Glidepaths are maturing beyond the basic concept of reducing equity exposure as funding levels improve. The next stage is about customizing glidepaths to align more precisely with a plan’s targeted hedge ratio, split between credit and Treasury LDI and long-term funding objectives. For some plans, this means integrating more LDI-focused strategies earlier in the glidepath to reduce risk and ensure stability as funded status improves. The key is to tailor the glidepath to the specific needs of the plan and adjust as circumstances change.
What’s changing with respect to liability measurement, and how does that impact LDI strategies?
Liability measurement is becoming more aligned with market realities. Some sponsors are now opting for more precise, mark-to-market funding liability measures that more accurately reflect current market conditions, including interest rates and credit spreads. This shift allows LDI strategies to become more effective at managing contribution risks, which is a high priority for many clients. With this improved liability measure, LDI can be fine-tuned to hedge risks in a way that was previously very challenging, offering better alignment between asset and liability measures.
As LDI strategies mature, what risks should pension plans be considering now?
One emerging concern is the potential for over-hedging, where large allocations to LDI are not appropriately balanced across the liability yield curve profile, exposing the sponsor to new risks even when the hedge ratio is high. In early stages of LDI, the highest priority is getting duration up, but it is possible to overdo it and introduce new risks.
Another one is concentration risk. As pension plans allocate larger portions of their portfolios to LDI, there’s a growing concentration in public fixed income assets, particularly credit. To address this, some plans are diversifying into new asset classes, like securitized private credit, which offers a different risk-return profile and helps mitigate risks associated with liquid credit markets.
Rates are currently high and spreads are low. Should this impact how sponsors think about LDI?
Yes, this is an excellent time to improve the liability hedge with LDI. For sponsors that were underhedged while rates rose, the funded status likely improved quite a bit. If and when rates fall again, underhedged plans are likely to see significant losses, but this can be mitigated by enhancing your liability hedge, effectively protecting yourself against rates falling.
Given spreads are low, it’s understandable if sponsors want to limit the amount they hold in credit, but looking ahead they should consider how the credit allocation could increase when spreads widen, and what other sources for credit spread the sponsor may want exposure to.
Disclosures
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