Liabilities Deserve Interest

In this article I’ll be taking a look at the rise of Liability Driven Investment (LDI) and how far pension plans and pension providers in the Canadian market are actually undertaking it in practice. The planning and intentions are well-placed, but it is the execution that could benefit from a change of direction. Incorporating a proper focus on liabilities within the investment strategy really is the next step up. In the second of my mini-series of blogs I’ll be taking a look at the rise of Liability Driven Investment (LDI) and how far pension plans and pension providers in the Canadian market are actually undertaking it in practice.

Certainly this seems to be an area of focus and good intentions, at least in appearance. But when you dig a little deeper there’s still more that can be done. Because of this, in this piece I’ll consider some of the key steps to help shift the focus from the asset and performance side to a more rounded approach that better matches the ultimate goal of meeting the liabilities of the plan.

The good work being done

The common rhetoric we see is certainly positive that a member focus exists in the industry’s thinking – with firms trying to identify themselves as trustworthy, member-driven and accountable around investments – as well as making outward attempts to show their communications and business practices reflect the same attitude. All of this is, of course, encouraging for members and paints a comforting paternal picture within the market.

There is also evidence of attention in the LDI area through a greater focus on longer term illiquid investing, such as infrastructure, which you can read about in my previous blog, and widespread commitments to solutions like fixed income and liability hedging strategies.

So there is certainly the appetite for a member-focused and liability-based approach in the industry, but equally there seems to be a little more understanding required around how to actually bring the focus of investment strategies towards this goal in the most effective way.

Improving the focus

The planning and intentions are well-placed, but it is the execution that could benefit from a change of direction – especially around how benchmarking and performance is measured with an LDI goal in mind. Most pension plans and advisors continue to judge their success by the returns they receive on their assets, hoping the numbers are all heading upwards. Similarly, investment managers live and die by their performance figures and how much they beat their benchmarks by – which in fairness the industry in Canada generally appears to be able to do at present. But the issue is not necessarily asset performance, but that it should be judged relative to the liabilities rather than the market.
A lot of good Asset Liability Management (ALM) work is being undertaken across the country, but again ultimately it is still often only evaluated against an asset benchmark. This can mean there is some unused potential in the strategy, which can be solved by a few simple changes to how everyone involved looks at the issue.

The solutions

Incorporating a proper focus on liabilities within the investment strategy really is the next step up from this initial work. It will involve a change of thinking, but one that could really benefit the plan’s target of meeting liabilities – that is to switch focus to the funding ratio.
By ensuring that the funding ratio is the focal point of all activity you can ensure that there is one common goal being met by everyone involved. There are then some changes you can make to ensure the new strategy is a success:

• Include everything - This new funding ratio focus should account for everything going on with the plan, broader than just its investments. Returns, cash flows and benefit payments should all be included in the big picture
• Incentivise – Given there is now just one goal to improve the funding ratio, you could consider rewarding those parties who make a contribution to improving this figure.
• Reporting – Rather than just asset performance and benchmarking, reporting should also include the changes in liabilities and projections
• Strategy management - Objectives that had been set for the plan should now be re-evaluated to ensure they are working towards improving the ratio. An assessment of contributions and payments should also be considered, as well as innovative ideas like removing some of the hedging aspects of the strategy

In summary - remember what’s really important

With all of this work it is important to remember why this shift in focus is being undertaken – to ensure the member is always kept firmly in mind. The ultimate promise of the pension plans will always be to pay the members their pension, to provide them with inflation protection and to maintain a level of trust that their future is secure. So my advice would be to make sure you align all of your processes to the idea of delivering this promise. LDI is a vital approach to have, but it is equally important to make sure it is being done to its full potential - rather than just with good intentions.