Are Your Risk Tolerance and LDI Glide Path in Sync? · 2019. 4. 25. · Hypothetical Glide Path Examples Four glide paths, different tracking errors For illustrative purposes only

Wesley Phoa, LDI Portfolio Manager, Capital Group

Luke Farrell, LDI Investment Specialist, Capital Group

Are Your Risk Tolerance and

LDI Glide Path in Sync?

The Plan Sponsor’s MissionDual accountability to participants and shareholders

Plan sponsors must seek to ensure:

• Security of benefits for participants

• Prudent and efficient financing of plan, for shareholders

Thankfully, participant and shareholder interests align:

• Participants derive security from a strong and sound company

• Shareholders do not want to bear the cost of a funding shortfall

LDI Can Help Plan Sponsors Meet ObjectivesA dynamic approach to liability-driven investing may be advantageous

Liability-driven investing (LDI) requires a different perspective:

• Investment outcomes should be measured relative to liabilities

• “Risk” redefined as the variability of funded status

− For example, an immunization strategy seeks to eliminate risk by

ensuring that changes in value of assets and liabilities offset each other

Moving toward fully funded status along a glide path makes sense:

• Follow a disciplined schedule

• Invest for return early on – let your assets work for you

• As funded status improves, switch to matching liabilities

A Guiding Design Principle: Downside ProtectionAs funded status improves, increase the downside protection sought

Reduce allocation to return-seeking assets, identify

specific expected volatility/return contributions

Shift long duration holdings

into A-rated corporates

Increase fixed-income

allocation

Match duration

of fixed income

assets to liabilities

Source: Capital Group.

For Glide Paths, One Size Does Not Fit AllEach plan sponsor’s risk tolerance is unique — their glide paths should be, too

It’s rational for each plan sponsor to react differently to changes in funded

status, de-risking at different rates depending on their unique circumstances

Each plan sponsor has its own risk tolerance, defined by:

• Subjective factors such as the preferences of trustees or other fiduciaries

• Objective factors: plan and plan sponsor characteristics

Key objective factors that influence de-risking include:

1. Plan size relative to the sponsor’s balance sheet

2. Whether the plan is open or closed

3. Correlation between investment returns and the sponsor’s business

1. Plan size relative to sponsor’s

balance sheet

• Economically, plan is part of

balance sheet; generates

volatility in proportion to its size

• Larger plans should de-risk

more quickly

2. Whether the plan is closed

or open

• Closed plans can be de-risked

with a high confidence interval

• Growth plays a more important

role in efficient funding of open

plans

• Relative sizes of retired and

active populations

A Closer Look at Three FactorsThese objective measures are critical drivers of risk tolerance

3. Correlation between sponsor’s

business and investment returns

• In a downturn, revenues of a

cyclical business may fall sharply,

possibly at the same time as

equities post losses and bond

yields fall. The sponsor may have

to make a contribution when it

can least afford to.

• Conversely, a plan sponsor

whose business is not cyclical

can afford to hold more risk

through downturns, and may

prefer to de-risk more slowly.

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

-1

0

1

2

3

4

5

6

7

8

12/1993 12/1997 12/2001 12/2005 12/2009 12/2013

Correlation MattersHistory suggests sponsors with cyclical businesses should be particularly careful

Sources: FactSet, Capital Group.

Free Cash Flow (USD billions) Returns

Free Cash Flow and U.S. Stock Market Returns (12/31/93 – 6/30/14)

Industrials (Left Scale)

Consumer Staples (Left Scale)

S&P 500 Returns (Right Scale)

How is the “Optimal” Glide Path Determined?Developing a framework to map a plan sponsor’s risk tolerance to an LDI glide path

Plan sponsors have various risk tolerances:

• Risk-averse sponsors reduce risk sooner

• Risk-tolerant sponsors may want to de-risk later, retaining their implicit

optionality (accept funded status volatility now, hope status improves in time,

bear cost in the future if approach doesn’t work out)

Finding the “optimal” glide path for a given risk tolerance is akin

to the static portfolio allocation problem, solved with mean-variance

efficient portfolios.

A similar approach could yield a solution for glide paths, but the problem

is harder to define, and harder to solve.

Plan

Characteristics

Objective Risk

Tolerance

Glide Path

Design

Monte Carlo Simulation: A Monte Carlo simulation was used to calculate the probable range of outcomes and

probabilities. Monte Carlo simulation is a statistical technique that, through a large number of random scenarios,

calculates a range of outcomes that are based on the assumptions included in this report. This simulation is provided

for informational purposes only and is not intended to provide any assurance of actual results. The simulation will not

capture low-probability, high-impact outcomes. While we believe the calculations to be reliable, we cannot guarantee

their accuracy.

For a single path of simulated monthly asset and liability returns, the path-specific risk is defined to be the realized

volatility of the funding ratio over the full simulation period (assuming no additional contributions by the plan sponsor),

and the path-specific return is defined to be the average funding ratio over the full period. In the full Monte Carlo

analysis, we define risk and return by averaging the above path-specific risk and return measures over all simulated

paths. So, on Slides 11 and 12, Risk Measure refers to the average, over all simulation paths, of the tracking error of

asset returns versus liability, measured over the 10-year simulation horizon. Likewise, Funded Status Measure refers

to the average, over all simulation paths, of the plan’s funded status averaged over the 10-year simulation horizon.

Hypothetical LDI-Related Data Shown in Subsequent Slides Were Developed Using a Monte Carlo Simulation

For illustrative purposes only.

This example is hypothetical

and does not reflect the results

of any particular investment.


4%

5%

6%

7%

5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

Volatility

Expected return

From a “Standard Edition” Efficient Frontier …A quick refresher on Markowitz

Asset Mix:

U.S. Equity

Global High Yield

Long Government

Long Credit

Long Corporate

0.82

0.84

0.86

0.88

0.90

0.92

300 400 500 600 700 800 900 1000 1100 1200

… to an LDI efficient frontierOptimal glide paths at different risk levels to liabilities

Asset Mix:

U.S. Equity

Non-U.S. Equity

Long Government

Long Credit


This example is hypothetical and

does not reflect the results of any

particular investment. Analysis

performed using Monte Carlo

simulation of assets and liabilities

(see page 9).


Efficient frontier: starting funded status – 78% , rebalance every 0.1%

Funded Status Measure

Risk Measure (bps/year)

0.7 0.8 0.9 1.0 1.1 1.2

0.7 0.8 0.9 1.0 1.1 1.2

0.7 0.8 0.9 1.0 1.1 1.2

Funded Status

Funded Status

Funded Status

0.82

0.84

0.86

0.88

0.90

0.92

300 400 500 600 700 800 900 1000 1100 1200

Efficient Glide Path is Sensitive to Rebalancing StrategyAdjusting the rebalancing step size has a measurable, but modest impact





Analysis performed using Monte

Carlo simulation of assets and

liabilities (see page 9).


Asset Mix:

U.S. Equity

Non-U.S. Equity

Long Government

Long Credit

Glide path rebalanced at

x% incremental change in

funded status:

x = 1%

x = 3%

x = 5%

x = 7%



0.7 0.8 0.9 1 1.1 1.2

B

C

A

Funded Status

Hypothetical Glide Path ExamplesFour glide paths, different tracking errors









0%

20%

40%

60%

80%

100%

0.7 0.8 0.9 1.0 1.1 1.2

0%

20%

40%

60%

80%

100%

0.7 0.8 0.9 1.0 1.1 1.2

0%

20%

40%

60%

80%

100%

0.7 0.8 0.9 1.0 1.1 1.2

0%

20%

40%

60%

80%

100%

0.7 0.8 0.9 1.0 1.1 1.2

Asset Mix:

U.S. Equity

Non-U.S. Equity

Long Government

Long Credit

LDI efficient glide path designs for a plan at 95% funded status

Risk measure: 450 bps/year Risk measure: 650 bps/year

Risk measure: 550 bps/year Risk measure: 750 bps/year

Hypothetical Example: Four Risk ScenariosEfficient glide paths showing average time to funded status vs. drawdown risk









2.4

2.6

2.8

3.0

3.2

3.4

3.6

3.8

4.0

0% 5% 10% 15% 20% 25% 30% 35%

Average Time to 100% Funded (years); 95% Initial Funded Status

Drawdown Risk: Probability of Funded Status Falling Below Specified Threshold

Threshold of 70%

funded status

450 bps/year

550 bps/year

650 bps/year

750 bps/year

450 bps/year

550 bps/year

650 bps/year

750 bps/year

Threshold of 85%

funded status

Hypothetical Example: Optimal Glide PathOn average, how long does it take to reach fully funded status?









2

3

4

5

6

7

8

9

0.70 0.75 0.80 0.85 0.90 0.95

Expected Time to Fully Funded Status (years)

Initial Funded Status

0.82

0.84

0.86

0.88

0.90

0.92

300 400 500 600 700 800 900 1000 1100 1200

Back to the LDI Efficient FrontierConsiderations when picking a point on the curve


This example is hypothetical and

does not reflect the results of any

particular investment. Analysis

performed using Monte Carlo

simulation of assets and liabilities

(see page 9).


Efficient frontier: starting funded status – 78%, rebalance every 0.1%



Plan

Characteristics

Objective Risk

Tolerance

Glide Path

Design

Key Takeaways for Plan Sponsors Quantitative rigor can be a powerful complement to qualitative judgments

• Plans need a glide path, and the choice of glide path matters

• Different plan sponsors will choose different glide paths

• Choice is determined by objective factors, as well as judgment

• Think of objective factors as determining the risk tolerance

• Map risk tolerance onto the glide path via the “efficient frontier”

• Ultimately, the choice still involves some informed judgment

The statements expressed

herein are informed opinions,

are as of the date noted, and

are subject to change at any

time based on market or other

conditions. They reflect the view

of an individual and may not

reflect the view of Capital. This

information is intended merely

to highlight issues and not to be

comprehensive or to provide

advice. Permission is given for

personal use only. Any

reproduction, modification,

distribution, transmission or

republication of the information,

in part or in full, is prohibited.

For financial professionals only.

Not for use with the public.

Documents

Are Your Risk Tolerance and LDI Glide Path in Sync? · 2019. 4. 25. · Hypothetical Glide Path Examples Four glide paths, different tracking errors For illustrative purposes only