Pension plan sponsors have traditionally directed money
managers to invest their pension assets with the goal of
maximizing returns within acceptable risk parameters.
Success is measured by how the assets perform relative to
certain benchmarks year over year. Seems like a reasonable
objective to any investor. However, a pension plan is not
any investor and its financial wellbeing is not driven by
asset performance alone. Rather, the measure of financial
success for a pension plan is its funded status – or the
interplay between assets and liabilities. While asset risk –
investing in equities over bonds – is a compensated risk
(in other words, there is a payback for taking on the risk),
interest rate fluctuations are considered uncompensated
risks and should be avoided to the extent possible. This is
what a liability-driven investing (LDI) approach strives to
do: mitigate the volatility of funded status due to interest
rate risk while also limiting market risk.
The concept of LDI was first introduced in the UK over 50
years ago but did not start to really gain traction in the US
until the early 2000s. Generally speaking, an LDI strategy
looks at pension plan asset allocation from the perspective
of total plan risk and return and includes the plan’s liability
as a risk factor in setting the allocation. Regardless of how
the assets perform, the liability can still fluctuate with
changes in interest rates, directly affecting the funded
status. In fact, the interest rate risk often outweighs the
asset risk. Let’s take a look at what happened in 2012 to
help illustrate this (fig. A):
83% funded
status
Plan A was fully frozen on December 31, 2010. As of
December 31, 2011, Plan A had assets of $100 million and
liabilities of $120 million, resulting in a funded status of
83%. Plan A’s portfolio was invested 60% in stocks and
40% in fixed income and had a return of 11.5% during
2012. Separately, plan assets increased by $3 million due
to a contribution and decreased by $4 million in benefit
payments to retirees. In total, the plan assets increased
by 10.5%. During the same time period, interest rates
decreased 55 basis points, resulting in an 11.3% increase in
liability. Including the interest cost on past service liability
offset by benefit payments, the total plan liability increased
by 12.1%. At the end of 2012, despite very positive market
returns, the plan’s funded status actually decreased to 82%.
Remember what this plan looked like in the perfect storm
of 2008?
This phenomenon generally occurs when plan assets are
invested in an asset-only framework and the investments
have a shorter duration than plan liabilities, creating a
mismatch and increasing interest rate risk. By increasing
the duration of the portfolio, the uncompensated risk can
be diminished. As a starting point, this may simply mean
lengthening the duration of your current fixed income
portfolio.
Given the current underfunding of most pension plans,
the idea is not to jump into an LDI strategy tomorrow,
but to for