How goals-based liability indices can help pension funds meet net zero targets

Goals-based investing (GBI) is now mainstream and global investors have also started to incorporate their values into their goals, specifically “ESG,” incorporating environmental, sustainability, and governance issues. Pensioenfonds Zorg en Welzijn (PFZW) and California State Teachers’ Retirement System (CalSTRS) have adopted detailed language in their objective statement to this effect.

Our goal is to help retail or institutional investors create portfolios that are consistent with their goals or values. We introduce the concept of goals-based or values-based liability indices (GLIdes) - “investible” portfolios that effectively replicate the goal spending cash flows and to which the asset portfolio can be benchmarked. A simple extension of the concept of the investible liability index (ILI), first implemented at Dutch pension fund Pensioenfonds Metalektro (PME), in the early 2000s, ILI greatly simplifies the practice of liability-driven investing (LDI). ILI is critical from a benchmarking perspective, and governance perspective.

But additionally, it could also be a useful tool for pension funds to meet their net zero targets. Where investors seek to achieve a long-term, dynamic goal such as “Net Zero Emissions in 2050, with a 50% reduction by 2030,” GLIdes can help. Theywill also lead to meaningful financial innovation including green (zero-coupon) bonds and green swaps and unique values/goals-based instruments. 

Goals-based liability indices 

PME created a simple, stable, and accurate benchmark for pension funds by mimicking/proxying liability cash-flows based on daily available swap indices. The only input needed is the projected annual liability cash flows and the swap curve. This ILI lends itself to two versions of GLIdes: a physical and a derivatives portfolio.

The physicals GLIdes approach

According to the Climate Bond Initiative, as of January 2023, approximately USD 1,889 billion worth of outstanding bonds could be labeled as “green”. GLIdes version 1, would create a physical ILI using a subset of green bonds that meet the criteria of the investor from this universe. This subset could be limited to just local currency bonds or they could be bonds in, other currencies hedged back into base currency.

Moreover, this could lead to the creation of zero-coupon green bonds to closely match the cash flows of every green pension fund. GLIdes will lead to product innovation in financial markets and the creation of a green zero-coupon curve, issuance of new green bonds. If the liability of the investor has any elements within it that are highly stochastic and not hedgeable with bonds, then equities could be included in the GLIdes.

The swaps approach

Swap/derivative instruments, ignoring the credit risk of the counterparty, are green instruments, as they are not a direct claim on the underlying bond or equity. With credit risk added back in, the investor now has the non-trivial credit risk of the counterparty, paving the way for “green counterparties” and “green swaps.” “Greenery” of the swap counterparty will be established by a rating-type entity, which currently rates counterparts on the alpha-numeric scale (e.g., AAA, AA). A similar green (or values-based) rating scale will need to be developed by independent third parties to enable such transactions.

The case of impact investing

One could take the view that AAA rated multilateral development banks (MDBs), like the International Bank for Reconstruction and Development (IBRD or World Bank), Inter-American Development Bank (IDB), Asian Development Bank (ABD), etc., are all involved in impact investing and directed toward achieving some or all of the 17 Sustainable Development Goals (SDGs) articulated by the United Nations. One can see that there is sufficient maturity/ MDB issuance for short and long duration liabilities or goals.

Adding in issuance by other similar institutions as well as in other currencies would greatly increase the outstanding balance for an investor to use to effectively construct their “impact GLIdes.” Given their AAA status, there could be an interesting market created for them as counterparties to create swaps to achieve the liability replication. Brazil has successfully created retirement and education bonds in 2023.

Dynamic goals: application to net-zero compliance

This takes us to the use of GLIdes to meet net zero targets. Asset owners have signed the Net Zero Asset Owner Alliance (NZAOA) requiring the reduction of greenhouse gas emissions by 50% by 2030 and zero emissions by 2050. This is a dynamic goal. Assume the fund has a “brown GLIde” and can articulate a completely “green GLIde” for their projected cash flow payments. 

They can set up a combination of these two GLIdes so that the proportion of brown and green reflects the practical realities of achieving the goals, while also setting a clear benchmark to measure the risk taken relative to the dynamic goal. 

One possibility is a 50–50 brown–green GLIde combination as of 2030 and a 100% allocation to the green GLIde in 2050. In this fashion, transition paths can be clearly specified and asset performance and risk relative to these paths can be effectively gauged.

In sum, GLIdes will improve benchmarking, governance, risk management and lead to financial innovation, especially in climate and impact finance.

The authors would like to thank Patrick Groenendijk and Ronald van der Wouden, co-authors for a similarly titled paper in the Journal of Portfolio Management, October 2023.