The Next Wave of LDI Evolution

Are traditional liability-driven investing (LDI) portfolios still optimal as funding ratios and, subsequently, fixed income allocations continue to rise? Once the fixed income component becomes the focal point of a plan’s asset allocation, diversification and yield benefits can be achieved by broadening the opportunity set. Within an LDI context, expanding the toolkit can allow the plan to maintain its hedging and funded status volatility objectives and incrementally improve returns to increase the funded status over time. 

Since LDI was recognized as best practice for defined benefit (DB) plans, sponsors have implemented investment strategies as a journey. In the early stages, sponsors opted to simply extend the duration of their fixed income using longer duration market-based benchmarks. The next phase of LDI involved a more customized approach to Treasury and credit strategies to better align with the liability risk profile. We’re entering a new phase of LDI evolution centered on addressing the question: “How do we diversify the growing fixed income allocation?”

Figure 1: Corporate DB average funding ratio¹

Source: LGIM America. Data as of December 31, 2024. 

In recent years, average funding ratios have steadily improved, reaching 111% at the end of 2024 based on our Pension Solutions Monitor.¹ As a result, many of our LDI clients have increased their allocation to fixed income, and this trend is likely to continue. According to a recent Cerulli report, 99% of corporate DB plan survey participants are at least somewhat likely to de-risk over the next 24 months.² For many of our clients, fixed income is now the dominant asset class within the asset allocation. As the LDI landscape evolves, we must explore new approaches to constructing custom hedging strategies. What options do plan sponsors have to improve diversification and, ultimately, funded status outcomes?

Figure 2: Fixed income correlation table³

Source: LGIM America. Data as of February 2006 to September 2024.

We believe this next wave of LDI evolution will prove that fixed income portfolios can explore options beyond traditional investments without sacrificing their hedging objectives. Furthermore, an expanded fixed income toolkit looks even more appealing in today's higher rate regime, allowing for more opportunities to enhance yield and return through active management.

• Intermediate Credit – Complement to existing long credit allocations as many plans mature and liability durations fall. 
• Short Duration Fixed Income – Inclusion within the completion framework can optimize collateral efficiencies and potentially enhance yield without jeopardizing liquidity. The potential for additional alpha within this component can effectively subsidize the fees paid for completion services.
• Securitized Assets – Incorporating securitized assets within custom credit portfolios can offer a spread pick-up while maintaining a high credit quality portfolio.
• Investment Grade Private Credit – Including within the credit allocation can improve diversification, increase spread and downside protection given inherent structural protections from covenant packages. 

Figure 3 – The next evolution of LDI investment strategy⁴

Source: LGIM America. Data as of December 2014 to December 2024.

The traditional LDI strategy consists of a long credit allocation and a custom Treasury portfolio that completes the interest rate hedge target. Enhanced LDI expands the fixed income investment toolkit by transitioning a portion of the long credit portfolio, in this example half, to investment grade private credit and allocates half of the custom Treasury component to a short duration fixed income vehicle. Illustrated in Figure 3, the Enhanced LDI portfolio has an improved funded status outcome while experiencing lower drawdowns over the course of our time horizon. To fully integrate these diversifying exposures within the LDI solution, it may be beneficial to employ a manager who plays a “quarterback” role, overseeing the LDI program from a holistic point of view. 

Figure 4 – Potential yield pick-up of enhanced LDI

Source: LGIM America and Bloomberg. Data as of December 31, 2024. Referenced indices include the Bloomberg US Long Treasury Index, Bloomberg US Long Credit Index, Bloomberg US Corporate ex Financials Index + 75 basis points, and Cash + 150 basis points.

The funding position of many corporate DB plans and the growing fixed income allocation give sponsors more flexibility to improve diversification and potentially seek more yield while still meeting their hedging objectives. LDI has long sought to minimize volatility and improve funded status outcomes. As DB plans continue to evolve and mature, so should the LDI strategy.

1. The analysis assumes a hypothetical plan with an asset allocation of 50% global equities and 50% long government/credit. Global equities follow the returns of the MSCI AC World Total Gross Index. We assume a liability duration of ~12 years and use discount rates based on a blend of the Intercontinental Exchange Mature US Pension Plan AAA-A and Intercontinental Exchange Retired US AAA-A discount curves. Prior to January 2023 the funded ratio of a typical US corporate defined benefit plan was calculated using an approximate duration of 12 years and a 60% MSCI AC World Total Gross Index / 40% Bloomberg US Aggregate Index ("60 / 40") investment allocation strategy incorporating data from LGIM America research, ICE indices and Bloomberg. The change to a "50 / 50" asset allocation reflects our understanding that most US corporate defined benefit plans have extended the duration of their fixed income as funded status has improved for the broader market. Furthermore, we believe that the duration of a typical plan's fixed income portfolio is better represented by the Bloomberg US Long Government / Credit Index compared to the Bloomberg US Aggregate Index.
2. The Cerulli Report: North American Institutional Markets 2023.
3. We use Bloomberg benchmark returns for STRIPS 15+, Long Government/Credit, Long Credit, Intermediate Credit, Emerging Market Debt and Securitized. Opportunistic Fixed Income represents the LGIMA Short Duration Opportunistic Fixed Income strategy returns. Investment Grade Private Credit represents LGIMA’s performance experience from January 2020 through September 2024. Prior to January 2020, we use the returns of the Bloomberg US Corporate ex Financials Index plus a spread appropriate for the illiquidity premium of private placements. Correlation indicates how closely two asset classes move together. In our correlation table, we highlight how different asset classes move in relation to US Long Treasury and US Long Credit, two traditional LDI strategies. A correlation closer to +1 represents a perfect positive relationship, while assets that are lower than 1 indicate they move less closely together, signifying a potential diversification benefit.
4. A representative stream of cashflows is used for the liability return and discounted using a AA corporate bond curve. The liability duration begins our time period mirroring an ~11-year duration and rolls down over time, reflecting a mature corporate DB plan. Traditional LDI asset allocation: 80% long credit and 20% custom Treasury portfolio to target 100% interest rate hedge ratio. Enhanced LDI asset allocation: 40% long credit, 40% investment grade private credit, 10% custom Treasury portfolio and 10% short duration opportunistic fixed income. Long credit and Short Duration Opportunistic Fixed Income represent LGIM America’s active performance over the time period. Due to the length of track record, we use the US Corporate ex Financials Index returns plus a spread to represent investment grade private credit.

Disclosures

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