LDI market reaches maturity, but growth opportunities remain

The growth of liability-driven investing assets was somewhat tempered in 2021 by a maturation of the market and a reluctance by some plan sponsors to enter the market, industry experts say.

That could change as interest rates are finally rising, they add.

Total worldwide LDI assets under management rose by 1.8% in 2021, to $3.9 trillion as of Dec. 31. The year-over-year increase was significantly less than the 13.9% gain reported in 2020.

Showing more growth during the year, however, were the top 25 LDI managers for U.S. institutional, tax-exempt assets managed internally, which totaled $1.033 trillion as of Dec. 31, up 14.3% from the previous year’s total of $904 billion.

The leading money manager of LDI strategies as of Dec. 31 was BNY Mellon Investment Management affiliate Insight Investment, which reported $828.3 billion in LDI AUM, up 3.7% from a year earlier.

Sweta Vaidya, New York-based head of solution design for North America at Insight Investment, said in a phone interview that growth in the firm’s AUM has slowed for the past couple of years in part because a number of asset owners, primarily corporations with frozen defined benefit plans, saw funding ratios improve enough that they hit their glidepath triggers and then engaged in pension risk transfer transactions.

“We’ll help the clients manage the process and reposition the portfolio for that eventual transfer,” Ms. Vaidya said, “but once that happens, that’s out the door.”

She also noted that over the past several years, it’s likely many corporate DB plan sponsors that have not yet initiated LDI strategies have continued to delay doing so in response to market volatility caused by the COVID-19 pandemic.

“To a lesser degree, I see the beginning of the pandemic with the volatility and just generally with the anticipation of rates rising, a lot of plan sponsors were hesitant to move into LDI programs,” Ms. Vaidya said.

Although fewer clients have launched LDI programs, those with existing programs have seen their LDI assets increase thanks to improved funded status.

Matt McDaniel, Philadelphia-based partner at Mercer, said improving funding ratios has meant that more corporate pension plans have been able to move further along in their glidepaths.

Mercer reported $255.4 billion in worldwide LDI AUM as of Dec. 31, up 36.8% from a year earlier, through its outsourced chief investment officer business.

In its own report, Mercer estimated the aggregate funding ratio of pension plans sponsored by S&P 1500 companies increased to 97% as of Dec. 31, from 84% a year earlier. It is the highest aggregate ratio achieved since year-end 2007 when it reached 104%.

Even during the first quarter of 2022, which saw a volatile equity market, Mr. McDaniel pointed out that Mercer’s estimate still increased because of rising discount rates, to 100% as of March 31.

The typical discount rate measured by the Mercer Yield Curve, a benchmark used to calculate discount rates, increased to 4.35% as of March 31, up significantly from 2.76% as of Dec. 31, lowering unfunded liabilities and raising funding ratios even as equity markets struggled.

“Even just in the first few months in 2022, we had a lot of clients hit triggers, derisk further and add to liability-hedging assets,” Mr. McDaniel said.

He also mentioned more plan sponsors are moving to an OCIO model.

“There are more and more clients adopting the LDI philosophy and moving to an OCIO model where they weren’t doing that before,” Mr. McDaniel said. He cited the pandemic as a primary driver of that adoption, which has continued into 2022.

“They’re re-evaluating the governance of those plan and asking whether they have the internal resources to be able to monitor these glidepaths,” Mr. McDaniel said, “or should they delegate these responsibilities to an OCIO provider?”

The growth of liability-driven investing over the past 10 years means more corporate DB plan sponsors are utilizing LDI strategies than ever before. Worldwide LDI assets are up 56.9% over the past five years, according to P&I data.

David G. Eichhorn, CEO and head of investment strategies at NISA Investment Advisors LLC, St. Louis, said in a phone interview that almost every corporate pension plan is doing some degree of LDI, at least in the form of increasing their allocations to long-duration fixed income.

For those utilizing customized LDI strategies that are using other credit and fixed-income instruments to hedge their liabilities, Mr. Eichhorn said, “the vast majority, at least in our sense, have picked their key partners.”

There is, however, room for growth, at least in terms of adding assets, he said.

“We actually think there’s meaningful runway left,” Mr. Eichhorn said. “If you look at the average plan, the average plan is really a little over 50% fixed income. Maybe the average plan is getting closer to 60% with the typical end state ... more like 80% to 85% LDI assets.”

He noted that in a $3 trillion LDI market, each time plans are ready to increase their allocations by up to 10%, “every 10% move, that’s (at least) $300 billion in reallocation” into LDI strategies. “On that dimension there’s a lot of (potential) growth.” Flows into LDI instruments would inevitably increase, Mr. Eichhorn said.

That growth might involve more precise hedging instruments as those funding ratios improve, Insight’s Ms. Vaidya said.

“For corporate DB plans as they consider their hedging programs, I’d expect to see more precise hedging along the yield curve,” Ms. Vaidya said. That might include more use of derivatives because she said U.S. plan sponsors have become more comfortable with the idea.

John Delaney, Philadelphia-based senior director and portfolio manager at Willis Towers Watson PLC, agreed more plan sponsors have been seeking more of what he calls “alternative derisking.”

“What we saw more in our client base is more of a broader discussion on kind of what’s the most efficient way for our portfolio to derisk? Is it buying more bonds or is it looking for more diversification in hedge funds, real assets, private investments?” Mr. Delaney said.

While he said clients that are “dead set” on terminating their plans are moving into more traditional LDI investments to lock in funding gains, “I’d say the appetite for traditional LDI, as it were, let’s call it long government credit strategies, has declined over recent years.”

Thus far, in 2022, Mr. Delaney said that theme has continued. Clients are asking, “How can we derisk without buying more bonds? ... Are there more efficient levers to pull here given the general view on rates?”

Ms. Vaidya noted that plan sponsors that might have been hesitant about beginning an LDI program as they waited for rates to rise are likely going to enter the market now that the time seems to have finally arrived.

“2022 and 2023 are going to be phenomenal years for flow,” she said, “whether it’s into derisking or into LDI.”

Matthew Nili, New York-based managing director, head of the U.S. and Canada liability-driven investment business at BlackRock Inc., echoed those sentiments.

“We’ve seen a big uptick in RFPs and plans seeking advice on derisking so far this year,” Mr. Nili said in an emailed response to questions. “I think there are a couple of challenges for some plans, ones that want to retain growth assets and others that are worried that rates can continue to rise. For the plans that want to retain growth assets, capital efficiency in fixed income instruments and completion management are the natural road ahead. For those that are focused on whether rates will continue to rise, I think we’d acknowledge that rates can increase, but that we’re potentially in the later innings. There are growing risks in the market, where rates could still play an important role in hedging against losing the incredible funded status gains made recently.”