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When More Is Less: Dialing Up Active Management in LDI Portfolios May Reduce Risk

Despite narratives claiming the contrary, a higher degree of active management within LDI portfolios may be the best path to lower funded status risk for DB plans.

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).