Implementing LDI in
Pension Plans
Tougher funding and disclosure requirements are spurring pension plan
sponsors around the globe to reconsider the context of how
they view their assets and liabilities.
A growing number of pension plan sponsors are considering liability-driven investment (LDI) as a framework for ensuring adequate funding of
future benefits. Proponents of an LDI framework
assert that managing a plan’s assets in the
context of its liabilities is the most prudent
way to ensure pension obligations are paid.
Plan sponsors, however, have been slow to implement these
approaches. Less than a quarter of pension plans worldwide
embrace an LDI strategy, according to a new study by Northern
Trust and Greenwich Associates (see “Use of LDI Strategies” chart, below). Fewer than one out of 10 pension plan trustees feels “very comfortable” with the approach. Not surprisingly, adoption rates are higher in the United Kingdom and the Netherlands, where regulatory changes have been in place longer. In the United States, these strategies are gaining a toehold. Many analysts,
however, expect interest to grow with recent regulations imposing
stricter funding and disclosure requirements on pension plans.
Why the growing case for liability-driven investing? Ravi Gautham, director of risk management and analytics for Northern Trust’s global investment solutions team, describes how traditional approaches to funding benefits are falling short.
“The typical pension plan,” Gautham says, “has roughly 60% of assets in equity and the bulk of the remainder in fixed income, most likely tracking a medium-duration index of about 4½ years. On the asset side, the plan faces reasonably good returns for the amount of risk — which is defined as the volatility of the assets. But when liabilities are added into the equation, you’re looking at a much riskier picture because the duration of the liability is much longer — about 12 to 15 years for a typical plan. These plans were
hurt over the past three to five years as interest rates have fallen. The returns haven’t kept up with the increase in the present value of their liabilities.”
Two fundamental changes are impacting how plan sponsors
view their asset-liability mix. The first is the time horizon in
which they operate. In the past, plan sponsors had several years
to smooth asset and liability valuations to fund their deficits. In
the U.S., as elsewhere, that’s changed. The smoothing period is
now limited to two years. Also, U.S. plan sponsors now must
fully fund their obligations — amortizing their deficits over seven
years. The second critical change is accounting regulations that
require plan sponsors to report the current market value of assets and liabilities on their corporate balance sheets.
“In the past, plan sponsors could afford the luxury of going to
perhaps riskier but higher-returning asset classes,” Gautham says.
“They now will be judged on an annual basis. Because these
liabilities also will impact their financial statements, they really
have to rethink the amount and types of risk they can take.”
That’s where LDI strategies can provide some solutions, says
Duane Rocheleau, managing director of Northern Trust’s global
investment solutions team. “LDI provides a framework for what
I call the three M’s — measuring, monitoring and managing the
inherent risks and tradeoffs in a portfolio — and looking at both
the assets and liabilities as key components of the LDI process,”
he says. “Within that LDI framework, managers can quantify the
liabilities to help determine the optimal investment portfolio.”
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Note: Based on interviews with managers of 1,050 funds in the United States, 224 in the United Kingdom, 197 in Canada and 217 in Europe.
Sources: Northern Trust, Greenwich Associates
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“Within that LDI framework, managers can quantify the liabilities to help determine the optimal investment portfolio.”
– Duane Rocheleau, managing director
of Northern Trust’s global investment
solutions team
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To get a better picture of a pension fund’s optimal investment
strategy, it’s crucial to begin with an assessment of its current
situation, or its starting point.
A plan that starts out overfunded, for example, might put the bulk of its investment in long-duration, fixed-income securities and comfortably meet its benefit obligations, Rocheleau points
out. That’s assuming the liabilities don’t continue to grow.
Underfunded pension plans, of course, need to earn a higher return. That usually means moving money away from fixed income and into equities and alternatives such as hedge funds. “The challenge is to create a mix that is in line with the plan’s risk budget. Multiple approaches can be devised,” Gautham says.
“One example is to use an overlay strategy to lengthen duration. This frees up capital for investments in areas with higher prospective returns.”
Rocheleau describes the transition to an LDI approach:
1.
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Analyze and characterize the liabilities; |
2. |
Quantify the relationship between the assets and liabilities; |
3. |
Develop and implement appropriate investment strategies; |
4. |
Monitor the account, rebalance the assets and liabilities
mix and tweak the investment strategy as necessary. |
To implement the appropriate strategy, a plan sponsor must
involve its accountants, actuaries, custodians and investment
managers. “Because every pension plan is unique, each solution
has to be customized,” Rocheleau says. “LDI is not a one-size-fits-all cure-all. It provides the appropriate framework for
understanding the risks associated with your plans and for
setting the investment course for funding future benefits.”
For more information, read Northern Trust’s white paper,
“Liability Driven Investing: Evaluating a Pension Plan’s Assets in
Context of Its Liabilities.”
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