DB Sponsors Should Review LDI Strategies

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.

Many pension plans are sitting on significant allocations to long bonds today that have generated much better than expected returns in recent years, and sponsors also have a schedule to put more into long bonds. “Sponsors have a significant decision every day for what to do with these investments that were designed to serve a purpose,” Nankof noted.He said options plan sponsors have, considering the implications of MAP-21, include suspending plans to move more money into long bonds and shortening the duration of long bonds to generate more reasonable rates of return for the next five years.  

The white paper warns that the impact of pension funding relief is expected to wear off over time. Because of this, and the inability to know the future interest rate environment, Rocaton suggests sponsors also develop a plan that enables them to re-engage their LDI programs when and if market conditions or plan characteristics change.  

There are factors DB plan sponsors should consider when setting their overall investment strategy, such as plan type, plan status (i.e. open, closed or frozen) and the importance of the effect of pension financials on the company. “Anything that would make plan sponsors more risk averse would lead them to keep long bonds or potentially add to long bonds in the current environment,” Nankof stated. He explained that for plans closed or frozen and for plans where plan financials can have a significant impact on sponsors’ bottom line, plan sponsors are more likely to keep the risk management framework they have in place. For plans open and growing and sponsored by an entity that will not be greatly impacted by plan financials and funding requirements, sponsors are more likely to suspend moves into long bonds or move money out of long bonds into shorter duration bonds or other asset classes.  

Rocaton also suggests in its white paper that DB plan sponsors review their current situation either through an asset allocation review or asset/liability study.