Time was when managing a U.S. defined-benefit pension plan was a pretty straightforward exercise. Plans were young, payments far in the future, and stock markets buoyant. Investing in equities generated returns that were broadly high enough to pay employees’ retirement benefits— the purpose of any pension plan—and sponsors could take a relatively relaxed view of contributions. No longer.
A combination of unprecedentedly volatile capital markets and regulatory change has fundamentally altered the relationship between a plan’s short-term assets and its long-term liabilities, exposing a wide (and widening) mismatch. Recent analysis by Russell Investments shows, for example, that in 2011 pension liabilities grew faster than assets for the 16 listed corporations that represent some 40% of all U.S. pension assets and liabilities, contributing to a combined net pension shortfall of U.S.$173 billion—43% higher than a year earlier. As a result, the focus of plan management for more and more U.S. corporate pension plans has shifted to one overriding concern: the risk presented by the plan’s funded status.
Liability driven investing (LDI) is a risk-management strategy with wide-ranging applicability. By managing assets in relation to liabilities, a pension plan sponsor with any level of funded status can reduce the volatility of that status and greatly increase its chances of meeting the fiduciary responsibility to provide a secure retirement for plan participants. Despite current qualms about the timing of implementation in volatile markets and the implications of momentous regulatory change, investment managers report that more and more U.S. defined-benefit plans are starting to consider LDI as a framework for de-risking.
One of the biggest decisions DB plans face is which benchmark best reflects their risk tolerance. Since the measure of success for any pension plan is the ability to pay benefits, the liabilities are, in effect, the benchmark. But as David Oaten, Managing Director at Pacific Global Advisors, points out, “There are multiple definitions of a liability, and it all depends on which one you care about— termination, funding, accounting, or something else. You know the assets get marked to market, so you need a liability that is similarly priced every day. You have to have a valuation mechanism to see how your mark-tomarket liability is moving over time. We don’t think anyone calculates that but us.”
For all the compelling reasons that make liability driven investing (LDI) a sound proposition for U.S. defined-benefit pension plans, the fact is that only about half of them have actually adopted such a strategy. Some, to be sure, are waiting for the perfect storm of rising interest rates and rising equity prices before they take the plunge. But investment professionals reckon that their hesitation also reflects the recognition that LDI represents a radical break with past practice—a break that makes many nervous.
“LDI changes things,” observes David Oaten, Managing Director at Pacific Global Advisors. “It makes plan management a more sophisticated, capital market focused issue. You need to put together a game plan for implementation. And you need to ask yourself if you really understand what you’re implementing. Do you know what your portfolio will look like in five or 10 years’ time—or whatever time horizon you care about? Also, do you realize that LDI solutions will become more sophisticated over time?”
Fixed income used to be the stabilizing component in pension fund investment management—the asset that provided safety while equities took the risk. But the 2006 Pension Protection Act, changes in the accounting treatment of pension plans, and volatile capital markets have changed all that. Today, plan sponsors are focused on reducing the risk of funding volatility by extending duration—and fixed income, in the form of long-duration investment-grade US corporate bonds, used as a hedge, has taken center stage.
Yet buying such bonds in current market conditions, with funded status plummeting and interest rates stuck in the mire, looks like a fool’s errand to many plan sponsors. As Peter Austin, Head of Fixed Income Solutions at T. Rowe Price, observes, “If you’re investing in long-duration US corporate bonds in these markets you know that yields are extremely low.”
Most sophisticated US pension plan sponsors view their asset-driven growth portfolios as complementary to their fixed-income hedging portfolios and manage them simultaneously—as dual aspects of overall asset allocation in a liability driven investing (LDI) strategy. What’s more, they employ a wide range of assets—from hedge funds, public and private equity, commodities and real estate, to such alternative fixed income options as high-yield and emerging-market bonds—as a means of diversifying their allocations.
“Interest-rate derivatives, for example, are widely used in LDI strategies to manage risk,” says Gary Knapp, Managing Director and Product Manager for all Insurance and Liability Driven Investment Portfolio Strategies at Prudential Fixed Income. “And options positions can help keep your growth portfolio buoyant in difficult market conditions. You can also purchase combinations of puts and calls to reduce the cost of protecting yourself against the biggest market downdrafts.” Hedge funds too have proven popular with some plans. “They can be very focused on different types of strategies—distressed, event-driven and so forth—so investors can take advantage of tactical or situation-specific opportunities,” explains Peter Austin, Head of Fixed Income Solutions at T. Rowe Price.
The de-risking strategy at the heart of LDI can take many forms, depending on the ultimate goal, or endgame, of the pension plan. And for some, especially frozen plans moving toward termination, buyouts or buy-ins will represent attractive options.
Buyouts, such as the one General Motors did this past summer, get pension risk off the balance sheet and transfer it to employees, either as a lump sum or as an annuity managed by third parties. In a buy-in, by contrast, the plan sponsor retains fiduciary responsibility, but pensioner benefits are covered by an insurance policy. Generous new rules around the calculation of lump sums were expected to kickstart a wave of such risk transfer moves, but so far, with most plans still significantly underfunded, that hasn’t happened.
“It’s just too expensive for most U.S. pension plans,” says Peter Austin, Head of Fixed Income Solutions at T. Rowe Price. “Interest rates need to normalize first, and funded status needs to improve.” And Kimberlee Lisella, Vice President, Customized Strategies at Cutwater Asset Management, agrees. “At this point, risk transfer is an expensive option,” she says. “You need to be significantly overfunded to finance it, and a lot of plans are stuck in the low ‘70s right now.” Meanwhile, David Oaten, Managing Director at Pacific Global Advisors, has additional concerns. “The retirees have to understand what’s being offered,” he says. “A lot may be scared to take a lump sum given financial market turmoil.”
There may, however, be mileage in an alternative— the sort of “insured” LDI strategy pioneered by Pacific Life Insurance Co. “Traditional LDI leaves risk gaps,” says Richard Taube, Vice President, Retirement Solutions Division at Pacific Life. “Much of the investment risk— credit spread risk, credit default risk, interest rate risk, and liquidity risk—falls on the plan sponsor. Insured LDI fills those risk gaps. It allows the plan sponsor, as holder of the insurance contract, to obtain an asset-liability match from two perspectives. From an economic perspective, the contract incorporates a cash-flow schedule that matches the plan’s projected pension benefit obligations. And from an accounting perspective, the contract value and the related pension benefit obligation move together in response to changes in discount rates since they use the same or similar discount curve. Since the contract value is guaranteed and all transactions occur at contract value, the investment risks are hedged for the pension liability that the contract covers.”