Words From the Wise: Martin Leibowitz on Pension Investing Challenges via AQR

Contributors:

Antti Ilmanen, Rodney N. Sullivan

Topic:

Portfolio Management

Introduction

Arguably the first bond quant on Wall Street, Martin (Marty) Leibowitz pioneered many central concepts and strategies that have come to form the foundations of modern fixed-income portfolio management. Dr. Leibowitz’s academic training — first in physics and later in mathematics — provided an important education to succeed at an otherwise daunting task. Earning his bachelor’s in liberal arts and a master’s degree in physics from the University of Chicago, and a Ph.D. from New York University, Dr. Leibowitz spent a quarter-century at Salomon Brothers as a Partner, initially as Head of Fixed Income Research, and ultimately becoming in charge of all research activities at the firm. Dr. Leibowitz then joined TIAA-CREF as Chief Investment Officer and Vice Chairman, and now serves as Managing Director in Equity Research at Morgan Stanley. Over the decades, he has written or coauthored more articles than anyone else in the Financial Analysts Journal and has contributed to numerous books on a wide range of asset management topics. He is one of only two people who have won all three top awards from CFA Institute. Apart from the many industry awards bestowed upon him, Marty consistently appears on the short list of people when other thought leaders in finance are asked to identify the most important and influential people in the investment profession.

 

CORPORATE DEFINED-BENEFIT PLANS

Antti Ilmanen: You are arguably the father of the asset-liability perspective in pension management. The approach has been called various things like asset-liability management (ALM) or liability-driven investing (LDI), but whatever name used, your ideas gave investors the tools in the 1980s for immunization, surplus optimization and more. They attracted institutional attention (and action) but in the 1990s moved to the background as defined-benefit (DB) plans increasingly focused on growing assets, especially via equity-oriented portfolios. More recently, ALM has made a comeback. Why was your prescient advice ignored for so long?

Marty Leibowitz: I don’t think I ever believed that a narrow view of things was the whole story. Every situation is different; the nature of the risks and time horizons that people can stomach dictates an awful lot of the final result. So, to say that you’re going to drive down to the point where you minimize your liability risk is, I think, too stark. There are too many other variables that enter into it.

Even back in the 1980s, when we were talking about surplus optimization, we were really noting that, hey, look, if you take a look at the liabilities and you’re concerned with how to manage the surplus, there are ways to likely improve the situation.

We never really intended for immunization to be the total advice or endpoint for an institution, but a starting point, really, which I think is helpful , even if it’s not the final solution. We tried to promote a combined perspective.[1]

Ilmanen: Some people are more pure-minded about the need to immunize liabilities.

Martin Leibowitz: Yes, Stan Kogelman and I had some huge debates with Larry Bader on this topic. Larry is a brilliant actuary with a photographic memory, so you can’t win an argument against him. I learned a lot from Larry, but never convinced him. I guess I should pride myself on having the prescience to bring an actuary and an accountant into Salomon Brothers’ bond research group. Larry is an actuary’s actuary.

Rodney Sullivan: One issue we’d like to discuss is why the asset-liability perspective was not more influential in 1990s and why corporate DB plans seem more inclined to pursue it now.

Martin Leibowitz: That’s an interesting case, because it’s not clear that plan sponsors have all of a sudden gone back and read all the literature, seen what Fischer Black[2], Irwin Tepper[3] or Larry Bader[4] had to say about it — that a pension fund should invest all in fixed income, because it was tax free, and then take the equity risk in the corporate structure. Clearly some broader forces have been in play.

Ilmanen: One broad trend has been the shift from DB plans to DC plans. The growing interest in LDI and various forms of de-risking in remaining DB plans seems related. Do both trends reflect waning willingness by corporate sponsors to underwrite pension related risks?

Martin Leibowitz: Well, corporate DB plans are slowly becoming extinct­ — going the way of the dinosaur. The world is turning to DC, certainly in corporate America, and amazingly, globally according to Roger Urwin’s stats with DC defined in a flexible fashion.[5]

Behaviorally, I think corporations are eager to shed that liability, no matter what. This is understandable, given how the market and investors view those liabilities and the potential impact on earnings, the associated cost of deficits and so on.

I think while corporate senior executives want to move toward minimizing the impact of plan fluctuations and to move toward ultimately unloading their DB plans, they also don’t necessarily want to incur excessive costs, by doing it at times when it seems unwise, especially when viewed in hindsight. Corporations look at interest rates these days as being low, and how can you argue with them? And they see that if interest rates rose to a level where they seem reasonable, and their deficits were low and tolerable, they would then likely try to immunize their plans.

Ilmanen: Some critics ask why such a transition was not done, say 10 to 15 years ago, when interest rate levels were higher. We just discussed the related trend to close DB plans. When DB plans were open to new enrollment, there was a stronger case for holding equities to support associated future wage growth. Was another reason for the change in attitudes that pension plans grew so large relative to their sponsoring companies?

Martin Leibowitz: Yes, that’s a biggie. The game has changed over the last 50 years. There’s been a huge increase in financial assets, far greater than the growth of GDP. The typical corporate pension fund used to be a peanut compared to where it was going to be and compared to the sponsoring organization’s market value. So, that changed a lot of the game, legitimately, as it is now at the point where the pension sometimes dominates the corporate capital structure. This means that the level of risk that’s appropriate for the plan is actually quite different now. Managing a pension fund in an environment where it’s such a huge presence in your corporate life is different than when it was a sidebar.

Ilmanen: So the tradeoff between reducing expected contributions and pension-related risks became less attractive merely because the plans grew larger and those risks less affordable. Some say that the tail began to wag the dog here.

I guess a related game changer must be the accounting change (FASB158 in 2006) which required showing market-based valuation of the funded status on the corporate balance sheet by using the corporate bond yield as the discount rate for liabilities.

Martin Leibowitz: Yes, it’s more onerous to have deficits when the funded status is more visible on the balance sheet. The stock market takes note of it in the corporation’s stock price. And

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