Confero Summer 2013: Issue 3 - Page 13

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