TY - JOUR T1 - Level 1 LDI: <em>Selecting an Appropriate Benchmark</em> JF - The Journal of Investing SP - 117 LP - 127 DO - 10.3905/joi.2012.21.2.117 VL - 21 IS - 2 AU - Aaron H. Meder Y1 - 2012/05/31 UR - https://pm-research.com/content/21/2/117.abstract N2 - We define level 1–LDI implementation as implementation done without the use of derivatives and an explicit liability benchmark. For level 1–LDI plan sponsors, we find that their biggest challenge is how to maximize the reward–risk efficiency of the capital that has been allocated to the liabilityhedging asset (LHA) component. We suggest that the answer to this challenge lies in getting the LHA benchmark right, both now and over time as the plan de-risks from the returnseeking asset (RSA) component to the LHA component.This strategic LHA benchmark is typically some combination of long-duration credit and long-duration Treasuries. Consistent with this two component structure, we posit that setting the appropriate strategic LHA benchmark is achieved by successfully evaluating 1) the appropriate split between the credit and Treasury components, 2) how to benchmark the Treasury component, and 3) how to benchmark the credit component.The main conclusion we draw is that to construct efficient LDI solutions and avoid poor funding ratio outcomes, it is essential to view these considerations from a total portfolio perspective. More specifically, we make the following three key observations. First, we find that the strategic split between credit and Treasuries is dependent on the size and composition of the RSA component. The bigger and more equity-like the RSA component, the lower the strategic allocation to long-duration credit should be. Second, we find that, in almost all cases, risk can be significantly reduced and returns enhanced by maximizing duration (i.e., via STRIPS) within the Treasury component. We find this to be true even when capital allocation to the RSA component is high. Third, as plans de-risk, moving from a market-oriented to a liability-aware strategy within the credit component can further help sponsors meet their risk–reward objectives. This may include limiting BBB-rated bonds, issuer/sector caps, and a risk-focused active management process.TOPICS: Fixed-income portfolio management, pension funds, volatility measures ER -