Slow and steady: A measured approach to pension funding

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By MaryAnn DiMaggio | 01 November 2007

Plan sponsors are getting the message: They're pulling risky investment strategies off the table in response to the Pension Protection Act (PPA), pending accounting rule changes, and this year's volatile marketplace.

By way of background, the PPA sets new funding standards and defines the discount rate to be used for valuing pension liabilities. The Financial Accounting Standards Board (FASB), which sets accounting rules, recently enacted new changes that will result in pension liabilities being shown on the financial statements, rather than in a footnote, so that changes in pension liabilities (and their corresponding assets) will directly affect companies' financial statements. These changes, coupled with recent market volatility, have brought the potential for volatility in plan funding levels to the forefront of pension discussions.

In response to this new climate, many sponsors of defined benefit (DB) plans are shifting their investment focus to longer-duration bonds and similar investments, and are also employing strategies such as liability-driven investing (LDI), which seeks to better match the risk/return profile of assets to pension payout liabilities. Because pension obligations are typically long-dated and span far out into the future, their values are very sensitive to changes in interest rates.

With LDI, the objective is to have the market value of assets move in tandem with increases (or decreases) in liabilities. Because liability obligations are sensitive to changes in interest rates, the asset portfolio must also be structured with similar interest-rate sensitivity. Without LDI, assets and liabilities may respond differently to market movements, which could result in volatility to the plan's funded status (the difference between the liabilities and the assets).

The new regulations and accounting changes, coupled with unprecedented levels of pension plan underfunding in recent years, have resulted in a fundamental adjustment in how companies fund their pension plans. Plans now understand that they need to adjust how they manage their employee retirement investments or risk seeing pension volatility reflected on their financial statements.

The industry-wide aversion to investment risk contrasts with the 1990s, when many funds relied on the booming stock market to grow their pension funds and eschewed the opportunity to fully fund their pensions or set aside extra for a rainy day. However, when the equity market declined for several years earlier this decade, and liabilities increased under a declining interest-rate environment, many retirement plans became underfunded.

The level of pension plan underfunding was a wake-up call to plan sponsors, the public, regulators, and legislators. Thus came the PPA, which established more stringent funding standards for DB plans (with the precise prescribed levels expected to be mandated for 2008 and beyond). The new law also defines the discount rate to be used for liabilities. What used to be a single rate associated with high-quality bonds now factors in the yield curve, including short-, intermediate-, and long-term discount rates, which allow for a more precise calculation of the value of liabilities.

Now more than ever, LDI matters

Given this new, stringent environment for pension funds, LDI or an LDI-like strategy works precisely because it is designed to reduce the volatility of a pension's funded status.

The extent to which high-quality, longer-term bonds are used will make it easier for the sponsor to meet its pension obligations, regardless of the market environment. By moving to longer-term bonds (and comparable investments)—including 10-, 20-, or 30- year-maturity bonds, versus five-year bonds—the fund profile more closely matches the fund's liabilities (pension benefit obligations). Thus, if interest rates move, causing liabilities to change, the bond portfolio mirrors those moves. Instead of tolerating the asset return volatility of the past, an LDI strategy allows the fluctuations in assets to be matched (or nearly matched) with the fluctuations in liabilities.

An LDI strategy makes sense even in the most turbulent of environments. For plan sponsor management, it means less of a chance for negative funded status news that must be reported to the CFO and CEO and also be reflected in the financial statements.

Break-out approach

The underlying principle of LDI is to manage the variability between asset performance and the performance of liabilities. LDI doesn't mean that a plan sponsor has to precisely match duration or cash flow of its liability obligations. Instead, LDI is a balanced approach where a plan sponsor can reduce fund volatility while also utilizing some assets that generate more attractive risk-adjusted returns. Each pension plan has different characteristics, which necessitate a customized approach in managing assets.

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For example, one approach under LDI divides portfolios into two parts, with one portion allotted to high-return-generating (albeit more risky) investments, and the second part allotted to assets (long-duration bonds or swaps) designed to match the performance of liabilities.

Ultimately, asset allocation and the decision on how much capital to commit to safer versus more aggressive investments depends on the plan sponsor's risk tolerance and the funded status of the plan, along with the characteristics of the workforce covered by the plan. Liability-driven investing opens up the options for sponsors in this new day of pension fund management.

MARYANN DiMAGGIO is director of fixed-income research at Evaluation Associates, a Milliman company, based in Norwalk, Conn. She follows the global fixed-income market, handles asset class research and evaluation, and recommends bond managers to client companies.