Aaron Meder, CEO of Legal & General Investment Management (LGIMA), has spent about a decade working on the topic of liability-driven investing (LDI), predominantly on behalf of the firm’s defined benefit (DB) plan clients.
Meder initially joined LGIMA back in 2010 for the express purpose of building out the firm’s LDI capabilities, essentially from scratch. He worked as a one-man LDI team for three years before moving to take on an expanded role in London. Two years ago, Meder returned to the U.S. to take the job of CEO, and since that time, LDI has remained a big focus.
“The biggest difference in the LDI space, comparing 2010 versus today, is how complex and multifaceted this topic has become,” Meder says. “Back then, we were talking about LDI as the idea of pension plans moving core fixed-income holdings to longer-duration fixed income, and encouraging them to use a performance benchmark with a longer duration profile that more closely resembled a pension’s investment horizon—for example, long government credit.”
Moving away from core fixed-income is an important first step, but over the last 10 years, LDI has become much more about analyzing liabilities and responding to these, Meder says. Pensions and their advisers still run long credit portfolios, but they have taken additional steps to create a truly tailored solution against a clients’ unique projected liabilities.
According to Meder, LDI in today’s context can lead to more significant changes in pension investing behavior than one might imagine. As the conversation around “DC LDI” intensifies, it is reasonable to think the same might be true one day for DC plan investing.
A big part of this conversation will naturally revolve around in-plan annuities, Meder says, but that’s not the whole story, especially given the regulatory uncertainty that many plan sponsors say holds them back from more fully embracing the offering of annuities in DC plans. Practically speaking, in the near term, Meder says using LDI in DC plans could also mean doing a reevaluation of the fixed-income investments offered. Just like DB plans have reconsidered holding a basic core fixed-income portfolio, which does not match their liability duration, and instead have embraced longer-duration fixed income, DC plan investors may consider doing the same, Meder says.
“Once you redefine what retirement income looks like, you start to redefine what the fixed-income portfolio looks like,” he explains, “including in target-date fund glide paths. In my opinion, the next 10 years is going to bring a massive shift from core fixed-income in DC plans to something that looks more like LDI, just like we saw in the DB plan market.”
One important caveat, Meder points out, is that LDI strategies must be informed by a plan sponsor’s goals for the DC plan. In other words, an LDI approach will look differently based on whether the DC plan is designed to be the main source of retirees’ income, or if it is supplemental.
“Full income replacement is not the goal of every DC plan,” Meder said. “Many are designed to be more supplementary in nature. The defining of goals is an important discussion to have when thinking about LDI, both for DB and DC plans.”
Learning from 403(b) plans
Reflecting on the topic of DC LDI, Patrick Rowan, senior managing director, retirement income strategies and products, TIAA, says there are a lot of ways that 403(b) plans are starting to look more like 401(k) plans in terms of streamlining administration. But the discussion of DC LDI, he says, is one area where 401(k) plans are actually (if slowly) moving to look more like 403(b) plans.
“One of the ongoing changes we are seeing in 401(k) plans, as an example, is that the qualified default investment alternative [QDIA] regulations have had a big impact on the entire market,” Rowan says. “At TIAA, because we believe annuities are key for a secure retirement, we have developed custom portfolios that qualify as QDIAs and include TIAA traditional annuities. We’re excited about this offering and are advocates for guaranteed income in DC plans.”
Rowan, like Meder, sees in-plan annuities as a core component of making DC LDI a reality.
“So, on the pension LDI side, the objective is to have the liquid cash flow in hand when you need it to pay your pension liabilities,” Meder said. “It’s really kind of the same idea on the DC side—a successful outcome is about having sufficient money available when you need it and for as long as you need it. Pension plans are managing this goal for a whole population of people, while DC plans are serving individual account holders.”
Rowan adds that, besides individuals’ sequence of returns risk, LDI strategies in DC plans have to consider longevity risk as well.
“It’s the main risk, in a sense,” Rowan warns. “Half of men who are 65 today will live to age 85, and a third will live to be 90. Women have better longevity projections than that. So longevity is a real and growing factor that people need to think about.”
Importantly, both Rowan and Meder say “retirement is always going to be tricky.”
“So often, life takes over and forces people to retire earlier or later than they planned,” Rowan says. “It’s often driven by emotion or personal situations. Say a spouse is ill, or work has become a grind or you get laid off. For these reasons, it is so important to plant the seeds about saving for a retirement paycheck earlier in the career path, as is the case with 403(b) plans. Thinking about the potential role of annuitization should begin early in one’s savings journey.”
Structuring a sustainable and individualized retirement paycheck is not going to be a focal point today for Millennials, but, Rowan says, younger savers can and should take small steps over time to address their multifaceted retirement liability. Baby Boomers and Generation X may be more open to this discussion and taking practical steps in the near term.
DC LDI will take time
According to Rowan, annuities have long been the bedrock investment underpinning 403(b) plans, but annuities are only in about 5% of 401k plans, and utilization with even these frontrunner plans remains low.
“We feel like that is largely because plan sponsors believe they lack sufficient fiduciary protections, not because they don’t see the importance of creating retirement paychecks instead of lump sums,” Rowan says. “I’m not a government relations expert, but I know that there are various proposals out there that would ease the offering of annuities, and we are hopeful that one or more of these will eventually pass. Our clients are also very hopeful about this.
“Until recently,” Rowan continues, “the 401(k) was always looked at as supplementary. Today, this has changed, and so I think the retirement income conversation will change quite rapidly. The whole retirement space is grappling with this change from accumulation only to addressing both growth and spending/income.”
From TIAA’s perspective as a provider of annuity products, Rowan says, it’s quite natural that the firm would see annuitization of DC plan assets as a pathway to LDI. Importantly, the firm advocates for partial annuitization with high-quality institutionally priced products.
“It’s a common misconception that when you buy an annuity, this means turning your whole asset base into a guaranteed income stream,” Rowan said. “In reality, annuitization is flexible. We generally see a recommendation from advisers that only, say, 40% of the portfolio be annuitized as a means to address longevity risk and sequence of returns risk. This subtlety often gets overlooked.”