LDI in a Risk Factor Framework

Abstract

Over $5 trillion in pension liabilities have been promised to individuals in close to 30,000 private and public pension plans across the U.S. Yet the vast majority of these pension plans do not fully incorporate their liabilities when making investment decisions. This article analyzes the fundamental risk factors common to a plan’s assets and liabilities and proposes a risk factor framework for LDI.

At a very basic level, pension plans should focus on assets minus liabilities, that is, their surplus portfolio. They should understand what investment and actuarial risks are expected to be rewarded. The surplus portfolio should be constructed to have a diversified set of positive exposures to rewarded risk factors. Further, these surplus exposures should be scaled in accordance to the investor’s conviction that the risk factor will be rewarded and to the extent to which it diversifies other risk factor exposures.

In this article, we demonstrate that pension plans that incorporate their pension liabilities into investment decisions in this risk factor framework can expect to achieve their funding status goals with considerably less uncertainty and better ensure that pension promises are kept.

TOPICS: Fixed-income portfolio management, pension funds, analysis of individual factors/risk premia