Eliminating volatility will allow for the systematic funding of the plans and, in some cases, accelerate the timetable for the termination of the plans. The methodology identified and commonly used for achieving “de-risking” is liability-driven investing (LDI).
Traditionally, pension plan investing has focused on maximizing returns. LDI reorients this traditional approach, and instead aims at reducing the risk to funded status through investment strategy and asset allocation. Its rationale: if the goal of a pension plan is to meet liabilities, then the investing goal should be focused on that larger plan goal. There are no hard-and-fast rules on what qualifies as LDI; in some respects, it is still evolving.
Furthermore, LDI objectives may differ from sponsor to sponsor, depending on ownership and capital structure. But all LDI strategies seek to quantify and more closely match plan investment returns to changes in benefit obligations that is, liabilities. In doing so, all LDI strategies seek to limit the swings in funded status, changes in contribution requirements, and impact on the balance sheet.
Despite the advantages offered by an LDI approach in de-risking a plan, the implementation of such a strategy was frequently delayed due to the uncertainties of the bond rate environment, and the significant drop in rates that had occurred (lower rates meant an increase in plan liabilities, along with concerns that if assets were transferred to fixed income investments, subsequent increases in rates would erode asset values). Although liabilities would decrease at the same time, the concern was that an increase in rates was both inevitable and imminent.
Many plan sponsors and committees made a decision to delay implementation until rates rose, in order to take advantage of the subsequent drop in liabilities and the possibility of better investment returns attributable to equity exposures. Rates have increased significantly to approximately the same levels that were available early in 2011. Because of this increase, liabilities have fallen and many plans have achieved improved returns on pension assets invested in equities. It may now be appropriate to implement an LDI strategy. This would lock in the recent gains earned on equities and begin de-risking the plan as well.
Implementation of an LDI Strategy
LDI can be phased in over time using a “glide path” (based on the funded ratio of the plan) to assist the committee in the timing of adding fixed income and reducing the equity exposure in the plan. This glide path would normally reflect the appropriate measure of liability (Projected Benefit Obligation, Accumulated Benefit Obligation, Funding Liability, etc.) and whether or not the plan has participants actively accruing benefits. A sample glide path is below.
In order to implement the strategy, the following actions will be necessary:
- Measure the current funded status of the plan, using current discount rates and the current value of assets.
- Adopt a glide path that directs the timing of adding to fixed income and reducing the equity exposure in the plan. The glide path should reflect the appropriate measure of liability and the future benefit accruals under the plan, if any.
- Initiate the LDI strategy by moving the existing fixed income portfolio to longer duration bonds to more closely match the duration of liabilities in the plan.
- In the equity allocation, reduce volatility by examining the asset allocation to achieve broader diversification. This will diversify the sources of return and risk.
- Identify appropriate fixed income strategies that reflect the duration of liabilities and changes in funded status.
- As funded status improves, reduce equity exposure and add to the fixed income allocation.
The process provides for funded status thresholds which, when reached, will trigger strategic asset allocation changes to reduce program risk and help lock in improvements in funded status, and it considers the plan’s funded status and the interest rate environment as it implements specific LDI techniques.
So what are you waiting for? Like most plan sponsors you missed the opportunity to de-risk your plan before the fall in interest rates which happened when asset returns were poor. Rates have recently improved and returns have been outstanding. Maybe it is time to take risk off the table through an LDI strategy.
By Lawrence R. Peters, CPA, EA
Lawrence R. Peters, CPA, EA is a senior consultant with Westminster Consulting where he leads the firm’s defined benefit practice. Peters is both a Certified Public Accountant and an Enrolled Actuary.
Westminster Consulting is an independent investment advisory and fiduciary consulting firm in Rochester, N.Y. Named a PLANADVISER Top 100 Retirement Plan Adviser in 2014, the firm is also CEFEX certified by the Center for Fiduciary Excellence. Learn more at www.westminster-consulting.com.
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.
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