For Some DB Plan Types IDL, Not LDI, Is the Answer
John Lowell, with October Three, says for two types of DB plans, investment-driven liabilities (IDL) is almost risk free for plan sponsors and provides more meaningful benefits to participants.
For traditional defined benefit (DB) plans, liability-driven investing (LDI) is used to align the movement of investments with the movement in liability. John Lowell, an Atlanta-based partner with October Three, says this does a good job if done properly.
However, for two types of DB plans, investment-driven liabilities (IDL) is almost risk free for plan sponsors, and at the same time, provides more meaningful benefits to participants, he contends.
Lowell explains there are two types of plans for which IDL is workable; variable annuity plans and market-return cash balance plans. “In a variable annuity plan, participants have a benefit a lot like with a traditional plan, but what makes it different is the plan establishes what’s called a hurdle rate,” he says. ”Assume the hurdle rate is 6%, in a given year. If assets go up by more than 6%, then plan participants get an increase in benefits related to returns over 6%. Similarly if returns are less than 6% benefits go down in relation to how much returns went below 6%, to the extent allowed by law.”
According to Lowell, essentially what happens for either of these plan types, and what makes IDL fundamentally different from LDI, is rather than locking in a low rate of return, and taking a plan that’s underfunded and making sure it stays that way because it can’t catch up, plan sponsors can generate assets to create a higher rate of return and to the extent they do, will generate higher benefits. With IDL, the plan and participants share risks. “Designed properly, they will wind up with a plan that will become well-funded, and once it is, it is almost risk free for plan sponsors, at the same time providing more meaningful benefits to participants,” he says.
Lowell further explains that with an IDL strategy, unlike an LDI strategy, there is no glidepath or funded status trigger to dictate a change in asset allocation to lock it in; there is nothing to lock in. As an example, he says, “Suppose you are a participant in a cash balance plan. The plan sponsor tells you you’re going to get the same return as the return on trust assets except that for technical reasons, the sponsor will guarantee you have no loss of principal and will cap your upside at a certain percentage. The cumulative rate or return cannot exceed a percentage specified. It depends on how the plan is designed, and that can be changed over time.”
“With IDL, I as a plan sponsor know that growth in liabilities is going to track the growth in assets,” he adds. “I will never get into a situation, if I do things properly, where the plan is not going to 100% funded.”
Lowell says October Three has found that given how pension finance works, using LDI also locks in massive costs, i.e. PBGC premiums, which make companies say they don’t want to offer DB plans anymore. On the other hand, in driving liabilities, plan sponsors are driving downside risks as well as upside rewards. They are almost able to lock in costs, then the whole idea of offering a DB plan as the primary retirement savings vehicle is no longer problematic.“The sad thing is, not a whole lot of plan sponsors have gone down this road. But, I have not heard of a single plan sponsor that has gone down this road that say they hate it, whereas those with a traditional DB plan want out of it,” Lowell says. “IDL is attractive to unions. What they like is that risk is shared by all rather than only being on the employer, as with a traditional DB plan.”
« District Court Approves Class Certification in Deutsche Bank Challenge