Rayan Rafay, CFA
Liability-driven Investing (LDI) is the standard approach to managing pension plans today. According to Vanguard, over 80% of all pension plans today are employing an LDI approach to investing. The overarching premise of LDI is that asset allocation must be informed by the nature, duration, and timing of the liabilities of an institutional investor.
Depending on the country, actuarial valuations of a pension plan’s liabilities is required anywhere from annually to triennially. The solvency or hypothetical windup financial position is an important measure for government agencies and employee representatives tasked with ensuring that obligations will be met, even in an insolvency event. However, LDI is primarily focused on the going concern or long-term funded status of a pension plan. This is what asset allocation is ideally designed around with a time horizon of at least five years.
LDI typically solves for volatility around the plan’s ability to meet its obligations. The other parameter tends to be the willingness of the plan sponsor to make contributions. If contributions are capped, then additional risk needs to be taken to meet plan objectives. Historically, the early version of LDI was ALM (asset-liability matching). ALM however, only focused on matching the duration of pension plan payments with the duration of plan assets, this approach did not solve for other types of risk such as inflation and the specific risks that are specific to the plan design of each pension plan.
Within the framework of LDI, residential real estate and specifically home ownership investments may be appropriate for achieving a plan’s objectives.
HOW DOES ASSET ALLOCATION WORK WITHIN AN LDI FRAMEWORK?
Asset allocation is a subset of modern portfolio theory (MPT) which has not materially changed since Markowitz first introduced the theory in 1952. The underpinning of standard asset allocation is laid out below.
Figure 1 – Efficient Frontier. FundBase – Etienne Baume
The efficient frontier is based on the idea that assets which are less than perfectly correlated with one another can be combined efficiently into a diversified portfolio. For a given level of risk tolerance, this portfolio can outperform its individual constituent. This approach to investing is agnostic of the needs of an individual investor.
Within an LDI framework, the approach adds to the consideration of what the objective of the investor is. For an individual, this could mean a charitable donation, the purchase of a second home, retirement funds or any other purpose. Our focus in this piece is the objective of a pension fund, which is the payment of pensions to pensioners within the terms of the pension plan design.
LDI begins with an actuarial valuation. Specifically, it focuses on the modeling and nature of a pension plan’s liabilities. If you would like information on what an actuarial valuation is, this piece is comprehensive in walking a reader through exactly what an actuarial valuation involves. The key assumptions of an actuarial report are laid out below.
- # of active participants
- # of deferred participants
- # of retired participants
- Obligations as laid out in plan design
- Mortality rate assumptions
- Inflation rate assumption
- Current salaries
- Assumed rate of salary increases
- Employer contributions
- Employer service costs
- Termination benefits/costs
- Current age of all participants
- Interest rate segments and associated rates
- Social security bases
- Percent married
- Spouse(s) age
- Timing of benefit payments
- Disability rate
- Retirement age
The inputs outlined above are used to determine a pension plan’s liabilities. This analysis is conducted by actuaries that must certify the results. The results are submitted to the governmental body responsible for the health of pension plans. Within the United States, ERISA is the legislation that outlines the obligations of a pension plan sponsor.
The outputs that are used to determine an optimal asset allocation for a plan are shown below.
- Adjusted Funding Target Attainment Percentage (AFTAP)
- Pension Benefit Guaranty Corporation (PBGC) premiums, if applicable
- Funding Target and associated shortfall/surplus
- Projected benefit obligation (PBO)
- Funded Status
- Pension cost
- The present value of accumulated benefits
- Duration and estimated cashflows for pension liabilities
Once this information is gathered, there is sufficient information for the liabilities to produce a modeled expected cashflow diagram. Historically LDI has been conflated with dedicated portfolio theory (DPT), however, DPT is much more simplistic in that it looks at a series of cashflows and structures a bond portfolio to match the cashflows of a set of liabilities. The reason why this approach is grossly inadequate is that it assumes that the assets and liabilities are subject to the same sensitivities. This is generally incorrect and a portfolio of bonds that are duration-matched with a set of liabilities are likely to react differently to changes in inflation, marriage rates, and a variety of other factors that are inputs into determining liabilities.
An LDI approach, in contrast, endeavors to understand the liabilities completely and then match it to a portfolio of assets that best meets the expected cash outflows. It does so by analyzing the underlying factors that drive liabilities and selects asset which has similar factor loadings This is the key distinction between LDI and other approaches such as ALM and DPT. LDI’s optimal portfolio has the highest correlation and cointegration with the determined liabilities. This is ideally derived through simulation testing over thousands of paths.
LDI within a pension fund often is implemented by using a liability portfolio and a growth portfolio, the objective of the liability portfolio is to explicitly hedge changes in the liability while the growth portfolio is focused on absolute return strategies. The amount of capital allocated to each is most commonly determined using a risk budget. For more information on this approach, we would suggest reading this piece.
WHAT DOES SUCCESS LOOK LIKE FOR A PENSION PLAN?
As discussed previously, at its core, success for a pension plan is its ability to make pension payments to its pensioners. In many instances, this is a perpetual objective (open pension plans) and is not on its own a reasonable way to measure success or assess the performance of a plan. Previously returns were the main driver for Chief Investment Officers of plans to measure their own performance. This has evolved over time, and now there are a variety of ways to measure success.
The funded ratio of a plan is simply stated the present value of plan assets divided by the present value of the plan’s liabilities. There are two primary methods by which to calculate the funded ratio. The solvency or hypothetical wind-up uses a lower discount rate because it assumes an immediate liquidation event that would result in assets being invested in long-duration bonds that match the duration of the pension plan. This measure is relevant for government and accounting regulations which are tasked with ensuring that pension plans have sufficient assets to meet their obligations. There are a variety of penalties that can be associated with an inadequate funding ratio including increased contributions to the plan, a higher degree of monitoring, higher contributions to PBGC premiums and potentially losing control of the plan at a material cost to the plan sponsor. Government plans in the United States are often excluded from such regulation which is unfortunate because many of them have the most acute issues.
The going concern funded ratio uses a higher discount rate that is intended to reflect the type of return the plan would achieve with its current asset allocation. It assumes that the plan continues to operate and the higher returns result in a higher funding ratio. However, the going concern funding ratio also contemplates future salary increases, changes in mortality, and inflation to a greater degree than the solvency funded ratio, which does not consider some of these factors at all.
The investment objectives of a pension plan are usually laid out in its State of Investment Policies and Practices (SIPP) and usually suggests a minimum acceptable funded ratio. Volatility is also a consideration, which is usually specifically laid out in the plan’s asset allocation and some form of risk-return measure (often the Sharpe ratio or unit of return per incremental unit of risk). Another key consideration is minimizing the contributions to the pension plan. Often an LDI plan will define its liability as the required contributions to the pension plan. Certain plan sponsors prefer predictable contributions even if they are higher, while others seek to minimize contributions to the extent possible which often results in a higher risk investment strategy. The benefit of being a long-term investor such as a pension plan is that higher risk investments tend to have a higher chance of paying off, the longer one’s time horizon.
To conclude, success for a pension plan is maximizing its going concern funded ratio while not risking its solvency funded ratio and managing contribution requirements as efficiently as possible. All three objectives can be toggled based on the preferences of the plan sponsor, but what has been laid out is generally true. The success of the asset performance should be relative to an appropriately-selected liability benchmark.
It is important to note here that within asset classes the appropriate benchmarks remain the passive benchmark for each asset class. Investment managers or strategies that fail to provide the passive return that is used in ALM and LDI optimization strategies should be removed and an alternative strategy or manager ought to be selected. An LDI strategy does not obviate this key role of a plan fiduciary.
RESIDENTIAL REAL ESTATE & HOME OWNERSHIP INVESTMENTS
Residential real estate can be accessed in a variety of ways. The three primary ways for a pension plan to access residential real estate are outlined below.
There are 22 public REITs that are within the NAREIT index with a total market cap of approximately $140bn. These REITs invest in a variety of multifamily and single-family properties. These REITs are entirely within the developed world and heavily skewed towards the United States and the United Kingdom.
These REITs historically have provided a dividend of approximately 3% and a total return of approximately 7%, which is a combination of income and price appreciation of homes. Since these REITs are public the funds exhibit equity-like volatility. Over the longer time periods the returns are representative of the residential real estate market, but during times of crisis or exuberance, the market price can overreact.
Unlisted REITs benefit from the tax treatment of REITs that tends to be favorable for pension plans. The top 100 real estate firms are listed here. Most of these firms operate mixed real-estate funds, that heavily skew towards commercial and multifamily, largely ignoring single-family residential real estate. The primary driver is the cost drag from having to manage thousands of small properties rather than a select few large properties.
Some of the major firms include Invesco, Blackstone, Pretium Partners, and Brookfield. Large pension plans typically require separately managed accounts (SMA), while smaller pension plans prefer to invest in a fund structure that provides opportunities for liquidity.
Private REITs exhibit very low volatility, part of this is due to the diversification within large private REITs, but the main driver is that assets within these portfolios tend to be valued once a year or using poor approximations of value (drive-by appraisal). These estimates of value are invariably leveraging index values for the area and so the results produce artificially low volatility. Returns are largely based on the specific investment strategy and its associated risk level. Private REITs will provide less observed volatility, but similar total returns and income to a public REIT.
Home Ownership Investments
Home Ownership Investments is an emerging opportunity to access price appreciation in residential real estate focusing primarily on single-family real estate. Properties are managed by homeowners rather than property managers and this type of investment makes a cash investment based on market value at the time (observed – purchase or estimated – appraisal and modeling). Home Ownership Investments (HOI) are leveraged exposure to home price appreciation without offering any exposure to rents or income. HOI portfolios are typically valued monthly and a portfolio of HOI assets is expected to produce a volatility of approximately 12-16% which is higher than private REITs but less than public REITs. The returns can generally be approximated as 2.2-2.8x home price appreciation in the country on a net basis.
Each of these three investments will exhibit material diversification across geographies. However, within a particular city there is likely to be materially more diversification with an HOI investment fund since these investments are made alongside the homeowner, and so the whole city is investable. Private and public REITs, on the other hand, will largely stick to the core of a city which results in homogenous investments within a particular city and across all the cities in the portfolio. For this reason, there is more systemic risk within a public and private REIT as compared to an HOI portfolio.
HOW COULD RESIDENTIAL REAL ESTATE AND HOIs FIT INTO AN LDI FRAMEWORK?
Residential real estate is the largest component of inflation as shown below.
Additionally, it is also the largest component of the economy (for the purposes of our discussion, we are using the US economy).
Real estate investments also provide interest-rate exposure that is attractive to LDI-focused investors but in very different ways. A public/private REIT approach that collects rental income will likely see rents increase as interest rates increase. This is largely driven by the fact that rising rates implies a growing economy and rising wages, both of which push rents up. Intuitively, rents go up to compensate the property owner for the increase in carrying costs of the debt tied to a residential property.
HOIs are only exposed to housing prices and the link between housing prices and interest rates is tenuous. From one perspective, if rates are going up, the economy is growing with wages and this should result in increased demand for real estate. The other perspective of the same scenario is rising rates will imply tighter lending standards and an increased difficulty qualifying for a mortgage with higher debt service costs. How these two factors play out is unclear. The BIS (Bank for International Settlements) has recently published a paper where the link between rates and housing prices is studied. The paper found that short-term rates may have an impact on housing prices as much as 5 quarters after the rise. Long-term rates, however, showed no material relationship with housing prices.
This is critical, a HOI provides full inflation protection but do not increase commensurate risk by increasing interest rate exposure. Pension plan liabilities are long-duration liabilities and as such are discounted using long duration rates. A HOI can provide inflation protection, upside exposure to price appreciation and no incremental risk exposure to interest rates. This combination can be quite powerful within a liability portfolio. Pension plan exposure to specifically inflation is typically 50-60% of all risk exposure. Inflation-linked securities however total only $500bn in value across the entire world whilst total pension assets exceed $100 trillion. There is not enough inflation protection to meet demand, and this is what makes residential real estate and HOIs in particular attractive and relevant.
Over the long term, it is extremely unlikely that residential real estate could underperform inflation, given its weighting of over 40%. A REIT approach gets you home price appreciation and a rental yield while HOIs would provide leveraged home price exposure (typically 2.2-2.6x exposure of the portfolio value), both approaches can fit well into an LDI framework. Leveraged exposure to inflation is a risk averse way of boosting returns within an LDI portfolio while maintaining a hedge to pension liabilities; this is a unique approach to liability hedging.
RESIDENTIAL REAL ESTATE WITHIN A PENSION PORTFOLIO
As a way to illustrate how residential real estate could impact a pension fund’s performance within an LDI framework, we have created a rearview look at how a typical pension fund performed over the past 20 years within a standard asset allocation, an asset allocation that put a portion of investment in a HOI portfolio (from fixed income) and one in which a portion of the portfolio was put into a basket of residential REITs. The key assumptions are laid out below.
The results are summarized below.
The main takeaway is that when the volatility of residential REITs and the return profile of the yield of residential REITs is taken into account, they offer an inferior return and poor risk-adjusted characteristics. However, HOIs provide incremental benefit to the portfolio without materially increasing risk, particularly over the long-term and when measured against the liabilities.
The main takeaway is that an LDI approach to investing necessitates looking at a pension’s assets exclusively from the lens of how they fare relative to the scope, size, and nature of a plan’s liabilities. Given the risk exposures of a typical pension plan, a residential real estate investment that is akin to a home ownership investment could be a reasonable and prudent addition to a typical asset mix.
There are limited assets with a correlation to inflation (as measured by CPI) and those that do exist are limited in size, relative to the natural demand for those assets. Residential real estate and HOI’s are promising solutions to this missing market.
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