Innovative Liability Management: Beyond Traditional LDI

The September 2022 UK gilt crisis was a watershed moment for liability-driven investing. In a matter of days, leveraged LDI strategies that had been considered low-risk nearly brought down the UK pension system. Margin calls on interest rate swaps forced pension funds to liquidate assets at fire-sale prices, creating a doom loop that required Bank of England intervention. At Ontario Teachers', we had already been questioning the conventional LDI framework before the UK crisis. Our concerns centered on three issues: excessive leverage in hedging portfolios, concentration risk in interest rate derivatives, and the assumption that liability discount rates would remain stable. Our alternative approach, which we call Dynamic Liability Management (DLM), incorporates several innovations. First, we've eliminated leverage in our hedging portfolio. While this means we cannot perfectly match our liability duration, it eliminates the margin call risk that devastated UK pension funds. We accept a duration mismatch of 2-3 years, which we manage through a combination of physical bonds and unleveraged swaps. Second, we've diversified our hedging instruments. Rather than relying solely on interest rate swaps, we use a combination of government bonds, inflation-linked bonds, credit with duration overlay, and swaptions. This reduces counterparty concentration risk and provides optionality that linear hedging instruments lack. Third, we've adopted a conditional hedging approach. Our hedge ratio varies based on the funding ratio and the level of interest rates. When rates are low (below 3%), we maintain a lower hedge ratio (50-60%) to preserve upside from rate increases. When rates are high (above 5%), we increase the hedge ratio (80-90%) to lock in favorable funding levels. This approach has added approximately 50 basis points of annual return compared to a static hedging strategy. Fourth, we've integrated inflation risk management into our liability framework. Many pension funds focus exclusively on nominal interest rate risk, ignoring the inflation sensitivity of their liabilities. We maintain a dedicated inflation hedging portfolio that includes TIPS, inflation swaps, and real assets, targeting a 70% hedge ratio for inflation-linked liabilities. The governance implications of DLM are significant. The board must understand and accept that the funding ratio will be more volatile than under a fully hedged LDI approach. In exchange, the expected long-term return is higher, and the risk of a catastrophic liquidity event is eliminated. We've found that clear communication of the risk-return tradeoff, supported by scenario analysis, is essential for maintaining board confidence. For the broader pension industry, the lesson of the UK gilt crisis is clear: risk management strategies that work in normal markets but fail catastrophically in stress events are not truly managing risk. The next generation of liability management must prioritize resilience over precision.