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Designing a liability driven investment (LDI) strategy

Better understanding risk appetites, objectives and goals Find out how JPMAM was able to incorporate the benchmark allocations of other fixed income managers in order to design a custom hedge benchmark allocation at each phase glidepath.

The Challenge

Reviewing client investment objectives
 
A Mid-West pension plan sponsor was pleased with recent funded status gains, and wanted to lock-in these gains by reducing investment risk.
 
The client has a strong relationship with J.P. Morgan Asset Management.  Additionally, they are advised by an investment consultant who has a long-standing relationship with J.P. Morgan, although minimal familiarity with our LDI capabilities.
 
Challenges faced by this client:
  • Basic LDI understanding
  • A broad glidepath existed in the client’s Investment Policy Statement (IPS), however:
    • Client was unclear as to how to implement a glidepath among multiple investment managers
    • Rudimentary existing glidepath that was never implemented
    • Lack of details around hedge allocations within the various glidepath phases
  • De-risking schedule not customized to unique liability profile and demographics
  • Ineffective plan funded status monitoring and reporting
  • Initial weariness/concern around using derivatives
 
De-risking: In asset/liability management, is a general term referring to strategies that better match the interest rate sensitivities of assets to liabilities; however, the tern in no way implies the removal of risk.
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Igor Balevich
Igor Balevich

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Our Approach

Customizing an LDI strategy
 
We believe in designing an LDI strategy by understanding the sponsor’s risk appetite and utilizing hedging instruments effectively. While doing so, we also maintain an exposure to growth assets to either recover a deficit in funded status and/or grow assets to align them with active members’ service costs. More generally, we feel that an LDI strategy may incorporate growth assets as a buffer to offset intrinsic risks that are unhedgeable.
 
Initially, the LDI team partnered with the client and the client’s investment consultant to understand the client’s objectives and goals. As part of the discussion, the LDI team offered general LDI education, which included how derivatives can be carefully used to help reduce risk in a pension plan. The client objectives and goals are outlined as follows:
  • Reduce risk and lock-in funded status gains by purchasing physical securities
  • Hedge portfolio:  As the funded status improves, the hedge portfolio allocation will evolve from using a market benchmark (e.g. Barclays Long Gov/Credit) to one that is far more customized in nature (e.g. term to maturity sleeves of the Barclays Long Credit benchmark index).
  • Growth portfolio:  Strategic asset allocation with the growth portfolio to be defined by investment consultant
After understanding the client’s goals, the team carried out risk modeling and analytic work for the plan. This included a holistic portfolio-level asset-liability modeling analysis to understand the plan’s asset risk relative to liabilities and in terms of risk budget and funded status. The charts below illustrate in more detail the asset-liability risk analytics conducted.
 
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The data/charts/graphs throughout this presentation are for illustrative and discussion purposes only. Source: J.P. Morgan Asset Management Inc.
 
Derivatives may be riskier than other types of investments because they may be more sensitive to changes in economic and market conditions than other types of investments and could result in losses that significantly exceed an original investment. Many derivatives will give rise to a form of leverage. Derivatives are also subject to the risk that changes in the value of a derivative may not correlate perfectly with the underlying asset, rate or index. The use of derivatives for hedging or risk management purposes or to increase income or gain may not be successful, resulting in losses.

The Solution

Developing a strategic glidepath
 
The end result was the development and implementation of a strategic glidepath via a partnership between the client, its investment consultant, and JPMAM as the completion manager.  In its role as the completion manager, JPMAM will take the lead in implementing the strategic hedge allocation as funding status improves, thereby reducing overall plan risk. 
 
The completion manager role also gives us responsibility for managing any interest rate exposure differences between other fixed income manager benchmarks and the overall strategic hedging benchmark.  We will also monitor and track the hedge effectiveness and funded status of the plan through time.
 
As the funded status of the plan improves, the plan's assets should de-risk by increasing its allocation to hedging assets.  The customization of the hedge portfolio also increases as the plan’s funded status improves.  In the diagram below, the client opted to accelerate its de-risking path by directly implementing a later stage of the glidepath based on rapidly improved funded status instead of moving through earlier stages first. 
 
JPMAM was able to incorporate the benchmark allocations of other fixed income managers in order to design a custom hedge benchmark allocation at each phase of the glidepath.
 
De-risking: In asset/liability management, is a general term referring to strategies that better match the interest rate sensitivities of assets to liabilities; however, the tern in no way implies the removal of risk.

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