Here are steps plan sponsors can take—in implementing a funding policy supported by liability-driven investing (LDI)—to reduce the financial volatility associated with pension plan funding.
First, determine the expected long-term cost of the plan under reasonable asset and liability assumptions and then determine whether the current benefit level still makes sense from a cost/benefit perspective. If necessary, modify the plan benefits to reduce the long-term cost to an affordable level. For example, plan sponsors might reduce future accruals, raise normal retirement ages, eliminate early retirement subsidies or change from final pay to career average or a cash balance formula.
Second, develop a contribution policy (e.g., a fixed dollar amount, a level percentage of payroll, or some other cost measure) that satisfies PPA and fits into the overall corporate strategy.
Third (and perhaps more technically), manage the short-term financial risks of the plan, which specifically means to:
- Set the investment benchmark equal to the market-based growth rate of the liabilities—PPA and FAS 158 use a market-based measure of liabilities. Then compare the risk and return of alternative portfolios to this benchmark.
- Measure the magnitude and financial implications of the existing asset-liability mismatch.
- Decrease the mismatch risk by increasing the allocation to fixed income and adjusting the duration to more closely match the duration of the liabilities. Derivatives, such as interest rate swaps and bond futures, can also be useful in this regard and play a key role in many current LDI strategies—but LDI can be implemented without them.
- Consider diversifying the "return-seeking" part of the portfolio into more than just U.S. and non-U.S. stocks. For example, consider real estate, private equity, commodities and hedge funds.
- Consider active management, including portable alpha strategies, as a way to increase returns without significantly increasing risk.
When deciding on the mix between liability-matching assets and "return-seeking" assets (in other words, how much asset-liability mismatch risk to take), the following questions should be critically examined:
- Is there a strong expectation that the mismatch risk will be rewarded?
- Is the sponsor in the financial position to bear the risk?
- Is there a strategic and tax-efficient use for the excess assets?
This course of action is designed to increase the predictability of DB pension plan funding and accounting results, which will ultimately lead to more restful nights for top executives and pension plan managers.