Liability Driven Investing (LDI)
      Where are we now?


April 22, 2010




© 2010 Towers Watson. All rights reserved.
Today’s Presenters

   Marko Komarynsky, CFA, Director of U.S. Fixed Income Manager
   Research
   Chris Wittemann, CFA, F...
Today’s Discussion

   Where we have been
   Lessons learned
   Where we are now
   Implementation considerations




    ...
Where We Have Been




towerswatson.com                                                                                   ...
What is LDI?

   Misconceptions about LDI
   LDI is simply a mindset
   Successful implementation should be tailored to th...
July 2007 to December 2008
         BarCap Indices                 Avg. YTM                           Avg. YTM            ...
January 2009 to March 2010
         BarCap Indices                 Avg. YTM                           Avg. YTM            ...
Historical Spreads
                                       400
                                                    Fixed In...
Lessons Learned




towerswatson.com                                                                                      ...
Lessons Learned

   We have witnessed volatile market conditions still searching for some
   sense of equilibrium
   Our a...
Which Camp Are You In?

                                                         Accommodative
                           ...
The Limitations of “On Average”

                                            Accommodative
                               ...
Measuring Current Investment Risks

      What could happen?          Sample pension plan’s exposure (in $ millions)
  (1 ...
Measuring Current Investment Risks




                                                                                   ...
Timeless Components of Liability-Hedging Allocations

                                  Pros                              ...
Pension Discount Rate Curves Are Not Investable

                9.50%
    Yield




                7.00%

              ...
Where We Are Now




towerswatson.com                                                                                     ...
GIC Market Views as of January 2010
 Economic Factor   Market View

 Inflation         Low but modestly rising inflation i...
Implications For Returns Follow From This Market View

 Liability Hedging Segment   Current View*                         ...
Is an Index-Based Approach Appropriate for Most
Investors?
   Index exposure to different sectors is unstable and not base...
The Index Has Not Been Static

   Low levels of Long Treasury bond issuance.
           Most bill issuance is rolling of s...
Should You Simply Focus on High Quality Credit?

                                                 Universe by Ratings¹
   ...
A Case for Treasuries




        Sources: BarCap and Towers Watson




                                                  ...
Implementation Considerations




towerswatson.com                                                                        ...
What has Towers Watson done in LDI?

   Search activity has been growing – search activity more than tripled in
   2009 an...
LDI Strategies
 Strategy              Pros                                                         Cons
 Physical/Cash Bon...
Portfolio Guidelines
   Able to customize with a separate                               Areas to potentially customize
   ...
What We Look For In A Manager
People                                                                                      ...
How We Do It
               Universe of managers         Market knowledge, contacts, publications, databases

            ...
Conclusions

   Who said LDI was boring?
   Volatility in the financial markets creates investment risks as well as
   opp...
Contact Details

   Chris Wittemann
       191 North Wacker, Suite 2100, Chicago, IL 60606
       +1 312 525 2438
       c...
Disclaimer

   The information included in this presentation is general information only
   and should not be relied upon ...
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Towers Watson Presentation: Liability-Driven Investing - Where are we now?

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This Towers Watson presentation explores the volatile markets of the last few years that have had serious implications for liability-driven investment (LDI) strategies. After so much upheaval, institutional investors are wondering where these strategies stand and raising questions such as:

How did we get here?
What lessons did we learn?
Where are we now?
What’s next?

Published in: Economy & Finance
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Towers Watson Presentation: Liability-Driven Investing - Where are we now?

  1. 1. Liability Driven Investing (LDI) Where are we now? April 22, 2010 © 2010 Towers Watson. All rights reserved.
  2. 2. Today’s Presenters Marko Komarynsky, CFA, Director of U.S. Fixed Income Manager Research Chris Wittemann, CFA, FSA, CERA, Senior Investment Consultant 2 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  3. 3. Today’s Discussion Where we have been Lessons learned Where we are now Implementation considerations 3 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  4. 4. Where We Have Been towerswatson.com 4 © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  5. 5. What is LDI? Misconceptions about LDI LDI is simply a mindset Successful implementation should be tailored to the governance budget (i.e. time, expertise, and organizational effectiveness) and reflect client context 5 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  6. 6. July 2007 to December 2008 BarCap Indices Avg. YTM Avg. YTM Cumulative 6/29/07 12/31/08 Return US Zero Coupon Swap: 10 Year 5.70 2.65 45.90% US Zero Coupon Swap: 20 Year 5.88 2.86 94.52% US Zero Coupon Swap: 30 Year 5.87 2.79 165.91% US Government: Intermediate 5.14 1.60 17.97% US Government: Long 5.29 3.15 35.86% US Corporate: Intermediate 5.83 7.62 -1.22% US Corporate: Long 6.52 7.41 -1.45% US Credit: Intermediate 5.76 6.80 1.39% 6 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  7. 7. January 2009 to March 2010 BarCap Indices Avg. YTM Avg. YTM Cumulative 12/31/08 3/30/10 Return US Zero Coupon Swap: 10 Year 2.65 3.98 -6.98% US Zero Coupon Swap: 20 Year 2.86 4.67 -26.04% US Zero Coupon Swap: 30 Year 2.79 4.77 -41.14% US Government: Intermediate 1.60 2.02 0.79% US Government: Long 3.15 4.55 -11.34% US Corporate: Intermediate 7.62 3.92 21.50% US Corporate: Long 7.41 6.20 21.53% US Credit: Intermediate 6.80 3.68 18.67% 7 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  8. 8. Historical Spreads 400 Fixed Income Spreads 350 300 Spread (basis points) 250 200 150 100 50 0 -50 -100 30 Year AA Spread-Composite Curve 30 Year Swap Spread Source: Bloomberg 8 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  9. 9. Lessons Learned towerswatson.com 9 © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  10. 10. Lessons Learned We have witnessed volatile market conditions still searching for some sense of equilibrium Our advice has become more time-sensitive and more collaborative with specific client objectives and views of our uncertain and complex future Augmenting stochastic analysis with complementary scenario analysis Exploring the tails improves understanding of surrounding uncertainty Those tails may indeed wag again Clarifying what is timeless vs. time-sensitive components of LDI investment strategy 10 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  11. 11. Which Camp Are You In? Accommodative Financial Conditions Scenario subset 1 Scenario subset 2 •Weak growth •Strong growth •Accommodative financial conditions •Accommodative financial conditions •Reflating policy and excess liquidity feeds •Developed govt. debt and debt-driven into asset price inflation and eventually household spending increase, resulting in actual inflation asset price and actual inflation Weak Strong Economic Economic Growth Scenario subset 3 Scenario subset 4 Growth •Weak growth •Strong growth •Constrained financial conditions •Constrained financial conditions •Due to the constrained liquidity conditions, •Policymakers reduce liquidity but real recovery potential is reduced and global economic growth continues, with unclear growth is weak impact on asset price and actual inflation Constrained Financial Conditions 11 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  12. 12. The Limitations of “On Average” Accommodative Financial Conditions Stagflation Sustainable ‘V’ recovery Central Weak Strong Economic Economic Growth Growth Weak recovery Sustainable ‘V’ recovery Stagflation Constrained Financial Conditions 12 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  13. 13. Measuring Current Investment Risks What could happen? Sample pension plan’s exposure (in $ millions) (1 in 20 event or tail event) to financial shocks? 2% fall in pension discount rate 30% fall in equity markets Killer pandemic scenario 13 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  14. 14. Measuring Current Investment Risks 14 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  15. 15. Timeless Components of Liability-Hedging Allocations Pros Cons Flight to quality during stress, Government liquidity and long duration Low yields and expected returns securities available (i.e STRIPS) Higher expected returns from Default/downgrade risk and lack of credit risk premium and used in Corporate issuer diversification; correlation with regulatory measurements of the equities in down markets liability Potential headline risks of certain Non-corporate Diversification and potentially issuers; uncertain role in liability Credit attractive risk-adjusted returns measurement Higher governance requirements (i.e. Synthetics Ability to tailor exposures administrative, educational, monitoring) 15 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  16. 16. Pension Discount Rate Curves Are Not Investable 9.50% Yield 7.00% 6.00% 6.00% 5.75% 5.50% 5.50% 0 Time 1 Bond A Bond B Bond C Average How do you invest assets to mirror this? Liability: single payment of 25,000 in ten years Liability (time 0) = (1.07) -10 * 25,000 = 12,709 Liability (time 1) = (1.0575) -9 * 25,000 = 15,115 Return (%) = 19% 16 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  17. 17. Where We Are Now towerswatson.com 17 © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  18. 18. GIC Market Views as of January 2010 Economic Factor Market View Inflation Low but modestly rising inflation in the US, transitioning from 1.5% to 2.5% over three years. Both short-term inflationary and deflationary scenarios are still possible given current environment. Long Treasury Central view is for long Treasury yields to rise very modestly from current Yields levels, but with high volatility, reflecting an increased inflation uncertainty premium. Swap Spread Swap spreads are currently negative, likely to revert to historical norm of modest positive spread. Credit Spreads Central expectation is that spreads will stay where they are currently, but will be volatile as uncertainty in the market remains. 18 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  19. 19. Implications For Returns Follow From This Market View Liability Hedging Segment Current View* Rationale (Relative to Government) Government n/a Expect long Treasury yields to increase modestly Corporate Neutral to slightly positive Expect credit spreads to neither contract nor widen in the near-term Non-Corporate Credit Positive This segment still offers some historically high spreads and add diversification Synthetics: Swaps Negative Swap pricing currently not attractive, but swaption pricing may present an opportunity for plans willing to adopt more sophisticated strategies 19 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  20. 20. Is an Index-Based Approach Appropriate for Most Investors? Index exposure to different sectors is unstable and not based entirely on fundamentals, especially during market turmoil Under current conditions, low weighting to Treasuries provides inadequate protection against “flight to quality” scenarios Once the “flight to quality” has occurred, Treasuries are overweighted just when they are more likely to underperform credit Index exposure is a function of amount issued by each credit Do you want your credit exposure to be based on market issuance? 20 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  21. 21. The Index Has Not Been Static Low levels of Long Treasury bond issuance. Most bill issuance is rolling of short term debt Credit spread movement changed the relative market valuations of Treasury vs. non- Treasury bonds Credit ratings in the investment-grade space have drifted downward Taxable munis (i.e., Build America Bonds) are estimated to be 20% of the Long Credit Index by the end of 2010 (from 7% at the end of 2009) Source: treasurydirect.gov 21 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  22. 22. Should You Simply Focus on High Quality Credit? Universe by Ratings¹ Barclays Capital Long Credit Index Holdings (1/31/10) AAA AA A BBB ¹X-axis scaled by numeric rating from highest quality rating to lowest quality rating. Source: Barclays Capital, Moody’s, S&P, Fitch 22 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  23. 23. A Case for Treasuries Sources: BarCap and Towers Watson 23 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  24. 24. Implementation Considerations towerswatson.com 24 © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  25. 25. What has Towers Watson done in LDI? Search activity has been growing – search activity more than tripled in 2009 and we placed $9 billion of client assets in LDI programs for 30 clients – mandates range from cash bonds to more complex derivatives programs We tend to focus on customized solutions however we realize that they might not always be practical for clients so we have worked with managers to help develop attractive standardized programs Tactical strategies and recommendations Worked with clients to unwind swap positions in 2009 and placed money into credit strategies Moving between derivatives and physicals Help to craft appropriate guidelines for clients Client education 25 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  26. 26. LDI Strategies Strategy Pros Cons Physical/Cash Bonds Easy to understand Liquidity can be an issue Fewer moving parts Diversification Lower governance Limited duration profile Reporting IR Swaps Liquidity Higher governance Customization Basis risk Theoretically unlimited Potential leverage duration Need to educate committee Cost Reporting Credit Swaps Customization Same as IR Swaps plus: No exposure to IR duration Perceived and real risk Futures Liquidity Basis risk Potential leverage Negative convexity KRD buckets Easy to implement Lower flexibility Collateral management Potential leverage Reporting 26 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  27. 27. Portfolio Guidelines Able to customize with a separate Areas to potentially customize account? Benchmark Size of investment mandate ($75M to Government/Credit mix $100M minimum) Level of governance budget Key rate durations Non-corporate credit exposure If not: Credit quality criterias May result in commingled long duration products “Plus” sectors exposure May result in passive lower cost Issuer limits implementation Role of synthetics? Level of active risk allowable to manager Liquidity/collateral requirements *Credit markets trade on a bid-ask spread basis (no commission costs). Larger managers may not necessarily receive more beneficial pricing, but may receive larger allocations given relationships with broker/dealers. 27 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  28. 28. What We Look For In A Manager People Process Talented and experienced Clear competitive advantage Small decision-making teams Superior research Depth of resources Efficient communication Cultural alignment Evolution of process Strong recruitment and training Strong portfolio construction Healthy staff turnover Transaction cost monitoring Client interests Business Long-term focus Performance fees Co-investment Account Management core Alignment of interests business area Asset management Portfolio manager Stable corporate structure company interests interests Strong compliance/technology Employee ownership Limitations to growth Employee ownership 28 28 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  29. 29. How We Do It Universe of managers Market knowledge, contacts, publications, databases Experience/stability of team, fees, process/philosophy, Desk-based research quant analysis (see Supporting Materials) Initial research meetings Meet key people, detail on process, independent thoughts emails Follow-up desk-based Read manager’s research notes & valuation analysis, further quant research & conf calls Follow-up meetings Sit in on internal meetings & stock discussions, meet more people Engagement Fees, capacity framework, vehicles Devil’s advocate One Area of Specialist Knowledge (ASK) member makes case against rating manager highly FREX 1 checklist 20 key points to cover before moving to Future Return Expectation (FREX) 1 rating ASK signs off ASK debates all key issues & decides whether to rate FREX 1 Global asset class head signs off 29 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  30. 30. Conclusions Who said LDI was boring? Volatility in the financial markets creates investment risks as well as opportunities Our role is to help clients make effective investment strategy decisions in real time 30 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
  31. 31. Contact Details Chris Wittemann 191 North Wacker, Suite 2100, Chicago, IL 60606 +1 312 525 2438 chris.wittemann@towerswatson.com Marko Komarynsky 191 North Wacker, Suite 2100, Chicago, IL 60606 +1 312 525 2362 marko.komarynsky@towerswatson.com 31 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. C:Documents and Settingsadam.hweeMy DocumentsTEST 1.ppt
  32. 32. Disclaimer The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm or accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments. 32 towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.

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