A lot has been said over the past fifteen years about what pension plans ought to do regarding liability-driven investing (LDI). But, with interest rates having fallen this year to levels we haven’t seen in decades, I think that what many plans will do is: not much at all. Whatever the position a plan is in, low interest rates make it difficult to make changes now.
Again, let’s be clear that I’m not talking here about the rights or wrongs of LDI in any particular set of circumstances; this blog is just about the practical, psychological realities of making a change when the 10-year Treasury yield has recently moved below 2%.
Consider first of all the LDI enthusiasts. A plan that was an early adopter of LDI has benefited from that position as interest rates have continued to fall. Even though the plan still has a net exposure to interest rate changes and falling rates have hurt funded status, they have hurt less than they would have done without the LDI program in place. Relative to peers, the LDI program has paid off. Suggest that it’s time to pull back on that decision, and the response is likely to be a polite but firm “no, thank you.” Increasing the size of the LDI program is a different story altogether: to commit new money to LDI following a sharp drop in rates would likely be seen as bad timing.
Now consider the LDI laggards. Perhaps for strategic reasons or, more likely, because of a view that interest rates were expected to rise, these plans have resisted making significant commitments to LDI. That has been a painful position as interest rates have fallen. But let’s be honest: having ridden interest rates down for this long, will these plans decide to move now? The potential fallout if this does turn out to be the bottom would be too great. Conceivably, someone could decide that holding off on LDI is just too risky and that it’s time to reduce the massive bet on interest rates. But that is a tough call to make having been so deeply committed to the position for so long.
Even though it would be possible to argue that not all of the reasons set out above for holding tight are completely rational, they are powerful. That’s why I believe it’s hard to see many pension plans either significantly increasing or significantly reducing their LDI programs in response to the recent sharp drop in interest rates.
Afterthought #1: these psychological currents—the behavioral considerations behind so many decisions—were a large part of the thinking that led to liability-responsive asset allocation (LRAA), an approach to LDI which is automatically tied to funded status, removing some of the behavioral barriers to change. The speed with which LRAA has spread has been a surprise even to those who developed it.
Afterthought #2: Maybe I’ve not been paying close enough attention, but it seems to me that the high profile of the chart that shows the U.S. Treasury yield compared to German, Swiss and Japanese rates (it seems to be everywhere right now) is a new thing. Unlike the charts we’ve been staring at for seemingly decades (“look how low the 10-year is compared to history”), this chart has a different message (“look how much lower it could go”.) This couldn’t be a sign that—contrary to what I wrote above—some investors are preparing to throw in the towel on their long-standing interest rate bet, could it?