The general advantages and disadvantages of an LDI mandate have been enumerated above. In the following section, considerations which are specific to plan sponsors are discussed.
Is an LDI mandate appropriate for my plan?
There are many factors to consider when a plan sponsor determines whether to pursue an LDI mandate.
First of all, it is important to know what actuarial assumptions were used to value the plan. The most important of these assumptions is the expected return on investments and how close that figure is to current market bond yields. If the assumed return on assets is below current market yields then the plan will be effectively locking in that spread as a gain on future investments. Unfortunately, for many plans the assumed return on investment exceeds current market yields which means the plan sponsor will be locking in losses on future investment returns.
Although the term “locking in” was used above, it is somewhat incorrect as there remain many factors which will continue to impact the liability and asset cash flows. On the asset side, reinvestment risk exists unless a cash flow matching strategy has been utilized. On the liability side, risks include mortality, retirement and salary growth to the extent that the plan’s experience deviates from the actuarial assumptions.
Plan Sponsor Business
An unfortunate outcome of the current environment is that plan sponsors are recognizing the correlation of their business with their pension plan’s results. When pension plans are overweight equities and a recession hits, typically the plan sponsor’s core business is suffering from the recession as well. Of course, if a plan sponsor’s business moves inversely with the business cycle, or if its core business tends to benefit from lower interest rates then an argument can be constructed to suggest that the pension fund should be overweight equities and/or underweight fixed income.
Rather than viewing the pension fund as an independent fund, it is appropriate to view it as another component of the plan sponsor’s balance sheet. Therefore, the overall risk of the pension fund (the risk of pension assets and liabilities together) should be viewed within context of the sponsor’s business risk and therefore it may be in the sponsor’s best interest to retain risk in the fund if it naturally hedges the sponsor’s business risk.
Financial Position
The financial position of the plan sponsor and the fund will have a bearing on whether or not to pursue a Liability Driven Investing mandate. A plan sponsor in poor financial position and whose fund solvency ratio is low may have an incentive to take significant risk in the plan as its survival is at stake. This approach was taken by the auto companies (not necessarily consciously), with equity allocations exceeding 70% in their plans even as their business was floundering. In retrospect this was quite unfortunate for their employees and pensioners as it remains unclear whether or not the Pension Benefit Guarantee Fund will make up the difference.
On the other hand a plan sponsor with a solvency ratio and whose business is performing will likely embrace the idea of reducing the volatility of plan surplus. The impact of financial position on the decision-making process likely depends on who owns pension plan surplus.
Finally, the risk tolerance of a plan sponsor will ultimately determine whether or not risk in the pension plan is mitigated. Once again, however, this may depend on the plan sponsor’s business. If the plan sponsor’s business is volatile then it might seek some stability from its pension plan’s results.
Use of Derivatives
While use of derivatives may be categorized as part of the implementation of an LDI mandate, it may be required in the deliberation of whether or not an LDI mandate should be pursued. Depending on the size and maturity of the expected cash flows of the liabilities, interest rate swaps may be required to achieve a proper hedging mechanism. Furthermore, derivatives can be used to alter the nature of the LDI mandate so that cash can be used to pursue portable alpha strategies if the plan sponsor chooses to do so.
There are many considerations for a plan sponsor for determining whether or not to “de-risk.” It is important to emphasize that a decision need not be instantaneous. A plan sponsor may choose, for example, to pursue LDI over a period of time, slowly cutting down on its surplus or deficit at risk. It is also reasonable to split the fund investment strategy by membership category. In that case, LDI would be used for retirees and deferreds while active members’ pension benefits could be invested using a traditional equity/fixed-income asset mix. A plan sponsor must review all aspects of its business and its ability to assume risk emanating from the pension plan as well as its current financial position before determining whether or not an LDI mandate is appropriate.
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Jonathan Jacob is managing director of Forethought Risk, which provides asset & liability management services to pension plans, insurance companies and asset management firms.