A Core-Satellite View to LDI

Thomas J. Kennelly III, senior investment strategist in the Investment Solutions Group at State Street Global Advisors recently participated in Pension & Investments Liability Driven Investing and Risk Mitigation webinar. Below are edited excerpts from his interview.

2022 was kind to most defined benefit plans, driven by rising discount rates. As pensions have become better funded, the focus on LDI has increased and the precision of LDI solutions has improved.

“Our philosophy around LDI is about more than just the products. It is the asset allocation oversight, manager oversight, trading, portfolio positioning around liabilities, liquidity management and risk management.” The core-satellite approach is important. “Building the satellite for excess returns and to provide diversification is also important. [Core-satellite] has to work in tandem,” said Kennelly. The breadth of investment capabilities — and experience — differentiate a successful manager. “Being able to navigate through the challenges that we’re going to face in the next two years is very important. Price is not the only factor: So is value for money.”

Kennelly deploys this portfolio construction technique, which consists of an index-like core and an actively managed satellite, both for the liability-hedging portfolio and the growth- or risk-assets portfolio.

“The core LDI portfolio targets a duration and hedge ratio with corporates and U.S. Treasuries,” Kennelly said, while in the satellite portfolio, active managers provide credit risk management as well as alpha above their stated index but also to help exceed liability driven returns. “Customizing across different duration targets, yield curve exposure, sector and credit quality has always been what we offer to our corporate plan sponsors.”

Each client’s funded status, liability profile and desired risk tolerance in terms of contribution and funded status volatility, drives the composition of the growth portfolio. For underfunded plans and open/active plans that need increased return and diversification, “their growth portfolio in addition to equities will potentially have lower beta equities, real assets, opportunistic multi-sector credit managers and perhaps select components of private market assets.” For well-funded plans far along their glidepath, the growth portfolio is constructed with a tighter focus on risk and downside protection, Kennelly added.

In addition, asset classes with hybrid characteristics can be appropriate, since they have both equity and credit correlations, such as high-yield bonds, emerging market debt and bank loans. “We gain our exposure through active managers, in a multi-asset credit strategy, where they can move across and within these asset classes with less benchmark constraints.” The higher income can help cover spread risk found in liability discount rates but also have lower beta to equities.

State Street Global Advisors is also seeing increasing interest in derivatives management, which offers greater capital efficiency and fewer disruptions to physical assets. “The completion or hedge ratio overlay manager positions a bond futures portfolio along with longer dated Treasury Strips to complement the existing LDI managers, and reduce asset-liability mismatch. A strong collateral management and liquidity assessment is critical when utilizing a derivative overlay.” Kennelly said. As plans move down the glidepath to full funded status, and the LDI program takes prominence from an asset allocation standpoint, further minimizing asset-liability risks to protect or hibernate a plans well-funded status can often best be achieved with a customized completion mandates.

Click here to stream the webinar.