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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.
Source: Capital Group.
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
For illustrative purposes only.
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).
Source: Capital Group.
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
For illustrative purposes only.
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).
Source: Capital Group.
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%
Funded Status Measure
Risk Measure (bps/year)
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
For illustrative purposes only.
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).
Source: Capital Group.
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
For illustrative purposes only.
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).
Source: Capital Group.
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?
For illustrative purposes only.
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).
Source: Capital Group.
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
For illustrative purposes only.
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).
Source: Capital Group.
Efficient frontier: starting funded status – 78%, rebalance every 0.1%
Funded Status Measure
Risk Measure (bps/year)
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.
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