Asset mix has been an important determinant in many defined benefit pension plans’ underfunded status. Many in the pension industry have adhered to a 60/40 equities/fixed income rule. Personal finance experts advise individuals to increase allocation to fixed income as they age, so why do pension plans not receive similar advice? It is assumed that a pension plan is like a revolving door, with little change to its overall structure, as new hires replace dying pensioners. Unfortunately, reality is not quite so simple.
Pension plans mature as pensioners live longer. Baby boomers enter early and regular retirement age brackets and fewer new employees are hired to replace those leaving due to technological efficiency. This inevitably leads to a need for greater allocation to fixed income and less to equities to reduce the risk to plan surplus. The equity market meltdown of 2008 raised awareness among many plan sponsors that the risk to surplus implicit in their plan’s asset mix was too great and has lead to considerations of reducing that risk by pursuing liability-driven investing (LDI).
What is LDI?
LDI is a type of asset/liability matching which can take many forms, the most optimal of which would be to transfer all risk to a third party—such as an insurance company—by purchasing annuities for all retired and deferred members. While the plan must currently retain the risk of active members of a plan, it can minimize this risk as well by purchasing incremental amounts of deferred annuities every year based on service credits and salary increases earned by these active members. The main benefit of this type of LDI is that all risks are now borne by a third party, while the cost of such a mandate would be the greatest drawback.
A secondary form of LDI, in which the plan sponsor bears slightly more risk, is through cash-flow matching. The plan sponsor purchases fixed income assets which approximately match the projected liability cash flows. The extra risks borne by a plan sponsor relative to the first form include inaccurate projections of liability cash flows and potential default of assets backing the liabilities. A variation of this form of LDI is duration matching the assets to the liabilities. Rather than fully matching cash-flows, this method attempts to minimize the interest rate exposure of the fund by buying assets whose interest rate sensitivity is equal to the interest rate sensitivity of the liabilities.
Finally, the most basic form of LDI is recalibrating the plan’s fixed income exposure to ensure that it is consistent with the implicit exposure of the liabilities. This would include a study to determine how sensitive the liabilities are to short-, medium- and long-term interest rates and lead to investment allocation of fixed income segmented by maturity. The benefit of such an approach is that assets do not have to be managed in a segregated account; the chief drawback is that with a greater level of approximation, the plan sponsor bears greater risk.
Does this mean that a plan sponsor should abandon equities altogether? Not really. Since certain aspects of a plan’s liabilities are economically sensitive, such as salary growth and inflation indexing, the plan should look to equities and inflation-sensitive assets to hedge these risks. Furthermore, a plan can invest in real estate as a long maturity cash-flow producing asset as long as it is prepared to accept the volatility of the asset price relative to the liability cash flows.
Advantages and Disadvantages
Prior to evaluating plan-specific considerations, it is important to understand the general advantages and disadvantages of pursuing a Liability-Driven Investing mandate.
The major advantages of the LDI framework include reduced surplus volatility, better integration of plan risk with the plan sponsor’s business risk and increased understanding of the nature of the plan’s liabilities. The primary purpose of an LDI mandate is to reduce the volatility of surplus or deficit of the plan rather than managing the risk and return of the assets without regard to the liabilities. By reducing surplus volatility, a plan sponsor simultaneously reduces undesirable accounting statement volatility.
Furthermore, during periods of economic hardship, equities as an asset class tend to decline. A plan sponsor would be responsible for increasing contributions to its pension plan precisely when it can least afford to do so. By better matching the assets and liabilities, significant drops in a plan’s funded status are unlikely. Finally, LDI frameworks create greater awareness among plan sponsor investment committees and asset managers of the cost and structure of the plan’s liabilities.
There are some disadvantages to the LDI framework, however. The primary disadvantage to LDI is educational in nature; plan sponsors believe that following implementation of an LDI mandate, the plan surplus or deficit will remain static. The variation of surplus depends on the return on assets versus the rate used to discount liabilities. Assuming the assets are primarily invested in AA rated bonds, these rates should be fairly close, but will likely not be equal. A secondary disadvantage of LDI occurs when a plan is in a deficit position. Since LDI tends to minimize the variance of surplus, this means that a fund in a deficit position will lock in high future contributions by the plan sponsor unless the asset yield significantly exceeds the assumed discount rate for liabilities.