The Benefits Canada 2011 ranking of the Top 100 Pension Funds paints an encouraging picture. With 97 of the listed funds posting increases in pension assets for the year, many plans are recovering nicely from the economic turmoil they faced just three years ago.
Still, the funded status of the average Canadian pension plan was just 73% at the end of 2010, according to the Mercer Pension Health Index. This, coupled with lingering economic uncertainty and an aging workforce that’s moving closer to collecting pensions, has led many plan sponsors to seek new ways to mitigate risk in their plans. Liability driven investing (LDI) is one de-risking strategy that’s increasingly coming into focus.
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LDI links a pension plan’s asset risks and returns with its liabilities. Regulatory and accounting changes in the U.K. and U.S. requiring plan sponsors to post the funded status of their pension plans on their balance sheet have altered how plan sponsors in those countries view pension liabilities and moved LDI to the fore. Similar changes are expected in Canada over the coming years with the introduction of the new International Financial Reporting Standards pension accounting standards, which is leading many Canadian sponsors to look at their plans differently.
“A pension is a benefit and a liability and, to a corporation, it’s debt. I think [plan sponsors] are starting to manage it more in an asset-liability framework, whereas in the past, the assets and liabilities were always treated separately. The mindset now is back to where it was 40 or 50 years ago,” says Paul Malizia, a principal in Aon Hewitt’s investment consulting practice.
Interest is growing, action is slow
But Louis Basque, vice-president with State Street Global Advisors, says that while an increasing number of plan sponsors are discussing LDI, few have actually implemented a strategy. He sees a few reasons for this chasm.
“At the very basic level, there might be a misunderstanding as to what LDI is and what it’s not. From our perspective, LDI is not a one-size-fits-all strategy,” advises Basque. He says people tend to look at LDI as only encompassing fixed income or immunization through bond exposure, which are only two elements of what he says is a broad framework into which LDI strategies fall.
Basque says Step 1 for pension plans looking to implement an LDI strategy is to understand the current funding status. “It all starts with funding status. Are we in a situation where we need to re-risk the plan in order to achieve the required investment returns needed to get to a fully funded position? That’s going to be a very different asset allocation discussion than with a plan that’s fully [funded] or overfunded, where it’s about mitigating downside risk and drawdown risk to make sure the plan remains fully funded.”
Another key consideration, according to Basque, should be determining how to adjust the LDI strategy as the plan’s funding status improves. “LDI is not just a set-and-forget strategy. It’s a dynamic process involving active oversight. As funding status improves, the asset allocation has to react to that new funding level, hopefully to bring the plan back to a fully funded level while at the same time reduce the allocation to risky assets.
Brendan George, senior vice-president with Aon Hewitt and leader of the firm’s investment consulting practice, advises plans looking to LDI solutions to set objectives up front, particularly with respect to risk tolerance and return requirements. He says plans also need to carefully identify what “liability” means to their unique situation—is their concern around accounting liabilities, solvency, going concern or something else? Then, plan management needs to determine which asset classes it is comfortable investing in (fixed income, real estate, commodities, etc.). Once management has developed the LDI strategy, it should test a few “what if” scenarios to ensure that the strategy works in different economic conditions.
Basque says this last point is key, given the continued volatility of the global economic picture.
“It has to be a solution that is flexible enough to evolve with the plan, and to be operational in various market conditions, not necessarily something that would be viable only if a specific interest rate target is to be reached or a specific funding ratio.”