HOOPP’s approach to LDI is unique; but there are other ways to derisk. In this Q&A, we speak with Don Raymond, managing partner at Alignvest and the former chief investment strategist at the Canada Pension Plan Investment Board, on what factor-based risk management involves and how it can help Canadian plans. Raymond was also a speaker at the Annual Pension Conference in Toronto.

What is a factor-based approach to LDI?

A factor-based approach to LDI extends standard asset-only factor-based methods for strategic asset allocation to incorporate liabilities. Larger plans are increasingly moving to factor-based approaches as they can provide a more intuitive and flexible approach to liability-based strategic asset allocation.

What does it involve?

Doing this involves four steps. The first step is to define risk factors spanning the (ideally investable) asset/strategy universe and the liabilities (e.g., growth, inflation, interest rates). The second step involves mapping assets and liabilities onto factors, i.e., determining their factor loadings. The third step is to develop forecasts of expected returns and the risk of the chosen factors over the time horizon of interest, typically 10 or more years. To forecast expected returns, investors can use methods based on equilibrium, risk-parity, anomaly, or current market prices, and to forecast risk, they can use methods based on covariance estimates.

The last step is to allocate risk across factors using your preferred methodology and using total balance sheet risk (assets vs. liabilities) to define risk using your preferred risk measurement. There are a few methodologies a plan can choose from to allocate risk (e.g., mean-variance and Black-Litterman, etc.).

When it comes to implementation, what type of pension plan can benefit more from factor-based approach, and why?

While all pension plans could benefit from a one-step, factor-based approach, the plans that would benefit the most fall into two categories. The first category is those pension plans in which a significant proportion of total balance sheet risk is presented by the liabilities (relative to cash). The second category is those plans that have strong or well-informed views on factor returns (e.g., belief in risk parity). In either case, a successful implementation will require more sophisticated analytical methods, investment processes, and reporting.