It’s been widely accepted that active approaches are essential to managing U.S. liability-driven investing (LDI) portfolios, but there is far less consensus about how much active risk and alpha to target. In recent years, a growing number of market participants have advocated for lower active risk (i.e., less discretion and a lower alpha target) in LDI portfolios. We disagree – and encourage plan sponsors to consider a higher active risk LDI approach.
The argument for lower-discretion LDI typically revolves around three themes:
- LDI is first and foremost a risk-reduction exercise.
- Therefore, the amount of active risk in LDI portfolios should be relatively low.
- Plan sponsors should thus rely on their return-seeking allocations for generating returns in excess of liabilities.
This narrative may sound straightforward and effective. However, a more thorough analysis of risk budget optimization for defined benefit (DB) plans suggests it doesn’t hold up. In fact, this narrative may have it backward. We believe that a more significant amount of active risk in LDI portfolios is the most efficient way to reduce asset-liability risk since it potentially enables plan sponsors to achieve return targets with a lower emphasis on return-seeking asset classes.
Reducing the “cost” of outperforming liabilities
The large majority of plan sponsors seek to outperform their liability return (or its growth rate). Doing so can help reduce a funding deficit, build a surplus cushion, overcome the high hurdles set by uninvestable liability discount rates or offset potential costs associated with improvements in longevity. DB plan managers have a range of options to target returns in line with their objectives.
At one end of the spectrum, Figure 1 shows that a plan sponsor targeting a 6% expected return could allocate 50% of assets to a passive LDI strategy and 50% to a return-seeking portfolio. Based on hypothetical return assumptions, this combination would meet a 6% estimated return target. Allowing for a moderate amount of active risk in the LDI portfolio (with a net alpha target of 50 basis points (bps)) achieves the same return target with a lower allocation to return-seeking assets (40% return-seeking/60% LDI). Finally, targeting a higher amount of net alpha in the LDI portfolio (100 bps in this example) enables the sponsor to maintain the same 6% return target while lowering the return-seeking allocation to 25% (25% return-seeking/75% LDI).