We believe that the primary risk in a defined benefit plan is the risk of underperforming the liabilities, not just the chance of having negative returns on assets. An ideal zero-risk portfolio is, in our view, a portfolio of Treasury bonds that is perfectly cash-matched to a plan’s liabilities. In our opinion, liability matching (not necessarily with all Treasuries) should be the neutral position for defined benefit plans.
The appropriate benchmark should reflect the duration and convexity of the liabilities. In many cases, we use a market benchmark that has a similar duration to the liabilities. In other cases, we construct a custom benchmark that looks very much like the liabilities. We also consider the degree of diversification versus equities (assuming the plan is not all fixed income). Generally speaking, the higher the quality of the benchmark, the greater the negative correlation of returns with equity returns, at least in the times when equities are doing poorly – and long high quality bond returns have been negatively correlated with equities surprisingly often.
We strongly believe that alpha transfer or duration completion strategies based upon adding duration to core portfolios via futures or swaps are not the best ways to structure long duration portfolios for the following reasons:
- The base index may not always have the right duration or convexity characteristics.
- An overlay strategy sometimes can add costs and perhaps negative convexity or a yield curve bet.
- While the universe of long securities is obviously smaller than the overall market, nothing precludes long benchmarked managers from using shorter securities when they are attractive. Futures and swaps can be used at that time to extend duration, but in our view shouldn’t be part of the strategy all the time.
A benchmark customized to the liabilities (which we have created for several clients) consists of the actual liability payments viewed as a series of zero coupon Treasury bonds that precisely match the cashflows of the liability schedule. To that sequence of yields one can add a suitable spread, e.g., the OAS of the Bloomberg Barclays US Long Government/Credit Bond Index, and price that portfolio of zeroes each month at the Treasury rate plus the spread. Then one can calculate monthly returns and link them to calculate quarterly and annual benchmark returns. The bond portfolio returns could then be measured against this benchmark – a benchmark that precisely matches the liabilities, not only just in modified duration and convexity, but also in partial (key-rate) durations too.
- Liability Driven Investment (LDI) accounts are actively managed long duration accounts that have similar durations to their pension liabilities and are measured against their liability streams
- LDI accounts are managed precisely against their liabilities using a custom liability based benchmark calculated by discounting the liability schedule at the Treasury spot rates plus the OAS of a long market benchmark
- The durations of our LDI accounts have typically ranged from 8 to 26 years
Eight portfolio managers are responsible for managing long liability-based fixed income accounts. We designate a lead portfolio manager and a back-up for each account. The lead manager is responsible for coordinating and implementing the team’s decisions for the individual accounts. The lead is also the key contact person for the client.