QFIP-128-18: The Evolution of LDI and the Role of a Completion Manager

Question 1

What are some of the main evolutionary catalysts for ”De-risking”

Answer 1

1. Increased market volatility of the funding status of pension funds
2. A steady increase in the premiums pension funds pay to the Pension Benefit Guaranty Corporation (PBGC)

Question 2

The main challenges to pension plans looking to implement a complex and customized de-risking strategy

Answer 2

1. Portfolio structure: Many plans distribute their fixed income allocation across several managers with different benchmarks
   
   • This provides the potential for diversified alpha, but can make it more difficult to identify where to take action when opportunities arise while managing potential basis risk
2. Plan governance: Pension plans have a lengthy and formal approval processes for adjusting an investment strategy (i.e. introducing new derivatives)

Question 3

List some of the responsibilities in the role of a completion manager

Answer 3

1. Detailed liability analysis
   
   • Analyze the liabilities and the benchmarks used in the LDI portfolio
   • Goal is to make sure the pension asset portfolio can neutralize the risk factors (i.e. duration) of the plan’s liabilities
2. Construct a completion portfolio
   
   • Develop a completion portfolio that effectively fills in the gaps in the liability hedge and aligns the risk factors in the existing asset portfolio with those of the liabilities
   • can be done using a combination of bonds and derivatives such as interest rate swaps.
3. Ongoing management
   
   • Work with the plan to achieve its targeted endgame solution

Question 4

Pension Plans Initial Steps to Implement De-risking

Answer 4

• Allocating more assets to fixed income,
• Extending the duration of the asset portfolio,
• and converting liabilities into lump-sum offerings

These strategies offer limited customization and hedging efficacy.

Question 5

Weighing the Case for Derivatives in a Completion Portfolio

Answer 5

A pension plan that utilizes derivatives can significantly decrease duration risk without making major changes to the overall asset allocation

• This allows the pension plan to hedge a much larger portion of the interest rate risk without sacrificing the expected return on assets often seen when shifting from equities to long duration bonds

Question 6

Drawbacks from Using Derivatives in a Completion Portfolio

Answer 6

1. collateral
2. margin management

Add basis risk and leverage if it’s used.