Liability Driven Investing
Despite the advantages offered by an
LDI approach in de-risking a plan, the
implementation of such a strategy was
frequently delayed due to the uncertainties
of the bond rate environment, and the
significant drop in rates that had occurred
(lower rates meant an increase in plan
liabilities, along with concerns that if
assets were transferred to fixed income
investments, subsequent increases in
rates would erode asset values). Although
liabilities would decrease at the same
time, the concern was that an increase in
rates was both inevitable and imminent.
Many plan sponsors and committees made
a decision to delay implementation until
rates rose, in order to take advantage of
the subsequent drop in liabilities and the
possibility of better investment returns
attributable to equity exposures. Rates
have increased significantly during 2013
to approximately the same levels that
were available early in 2011. Because
of this increase, liabilities have fallen
and many plans have achieved improved
returns on pension assets invested in
equities. It may now be appropriate
to implement an LDI strategy. This
would lock in the recent gains earned
on equities and begin de-risking the
plan as well.
Implementation of an LDI Strategy
LDI can be phased in over time using a
“glide path” (based on the funded ratio
of the plan) to assist the committee in
the timing of adding fixed income and
reducing the equity exposure in the
plan. This glide path would normally
reflect the appropriate measure of
liability (Projected Benefit Obligation,
Accumulated Benefit Obligation, Funding
Liability, etc.) and whether or not the
plan has participants actively accruing
benefits. A sample glide path is attached
(see Fig. A).
In order to implement the strategy, the
following actions will be necessary:
•
Measure the current funded status
of the plan, using current discount
rates and the current value of
assets.
•
Adopt a glide path that directs the
timing of adding to fixed income
and reducing the equity exposure
in the plan. The glide path should
reflect the appropriate measure
of liability and the future benefit
accruals under the plan, if any.
•
Initiate the LDI strategy by moving
the existing fixed income portfolio
to longer duration bonds to more
closely match the duration of
Sample Glide Path
Allocation to Fixed Income (matched to liability duration) as a function of Funded Status
Funded Status-based
on Projected Benefit
Obligation
75%
80%
85% 90% 100% 105%
110%
Allocation to Long
Duration Fixed Income
40%
40%
50% 60%
90%
70%
80%
liabilities in the plan.
•
In the equity allocation, reduce
volatility by examining the asset
allocation to achieve broader
diversification. This will diversify
the sources of return and risk.
•
Identify appropriate fixed income
strategies will be identified to
receive a transfer of assets in
accordance with the duration
of liabilities and changes in our
funded status.
•
As funded status improves,
reduce equity exposure and add
to the fixed income allocation.
The process provides for funded
status thresholds which, when
reached, will trigger strategic
asset allocation changes to
reduce program risk and help
lock in improvements in funded
status; and it considers the plan’s
funded status and the interest rate
environment as it implements
specific LDI techniques
Conclusion
So what are you waiting for? Like
most plan sponsors you missed the
opportunity to de-risk your plan before
the fall in interest rates which happened
when asset returns were poor. Rates
have recently improved and returns
have been outstanding. Maybe it is
time to take risk off the table through
an LDI strategy. n
Fig. A
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