October 9, 2012 (PLANSPONSOR.com) – A white paper from Rocaton Investment Advisors suggests market conditions combined with recently passed pension funding relief justifies a new look at liability-driven investment (LDI) strategies.
“[Defined benefit plan] sponsors shouldn’t just accept that what was put in place five years ago is serving the same purpose today and still has the strength of argument it did then,” Joe Nankof, partner and head of asset allocation research at Rocaton Investment Advisors, told PLANSPONSOR. “Sponsors should be prudent about evaluating the market at all times and evaluating how that and new regulations affect allocation decisions.”
Nankof explained that LDI can be viewed as a form of insurance where defined benefit (DB) plan sponsors pay a premium to hedge a risk. The risk is interest rate risk inherent in the liability of the pension plan, and long bonds hedge that risk at a cost. The cost comes from sponsors sacrificing returns, because other asset classes would generate better returns than investment grade fixed-income. Nankof said two things make the argument for LDI weaker than five years ago, opportunity cost is much greater because of the low interest rate environment, and the recent passage of the Moving Ahead for Progress in the 21st Century Act (MAP-21) diminishes the hedging benefits of long duration bonds relative to funding liabilities. MAP-21 will reduce contribution requirements for most corporate plan sponsors on absolute level and reduce volatility with interest rate moves as well, Nankof explained, adding that if funding valuations are not moving as extremely, and plans are invested in long bonds, the match between assets and liabilities is not as close.