Take volatility out of your defined benefit plan using a liability-driven investing strategy
Market volatility can challenge anyone managing a defined benefit (DB) plan. But in 2020, major market fluctuations have been piling on with low interest rates, mortality table updates, and Pension Benefit Guaranty Corporation (PBGC) premium increases.
All told, it can be a tough time to meet payment obligations to participants.
While no one can prevent DB plan volatility, there are ways to help manage it—while also working to maximize earnings on return-focused investment options.
Why consider liability-driven investing (LDI)?
An LDI strategy tends to manage volatility better than other strategies, like those that only focus on maximizing the investment return (known as a “total return” strategy).
LDI helps manage your assets in alignment with your plan’s specific future liabilities, while total return strategies just aim to increase assets based on peer benchmarks.
In addition to helping manage volatility, LDI may help in other ways.
- Limits excessive upside or downside risk
- Provides enhanced fiduciary oversight of investment allocation decisions
- Generates higher expected “real” returns over time
- Reduces accounting expenses
The overall goal of an LDI strategy is to review your DB plan’s liabilities and invest the assets so they react similarly when interest rates change.
How does LDI work?
It works by matching the duration of a plan’s assets with its liabilities (promised benefit payments to participants.) This can help stabilize contribution amounts, funded status, and plan expenses.
What is duration?
Duration is the weighted average of the time period for when the pension plan’s liabilities are due.
One approach to an LDI strategy could involve several durations.
- With this tactic, you’d create different “buckets” of duration depending on employee demographics and when corresponding liabilities are due.
- Your fixed income investment strategy would then align these “buckets” with bonds of a corresponding duration. For example, younger employees would have a longer duration than older employees.
3 steps to setting up an LDI strategy
If you decide it’s right for you, here’s a three-step process to set up an LDI strategy.
1. Consider how different allocations interact with the plan’s liabilities.
The most thorough way to do this is with an asset liability modeling study where an actuary uses sophisticated software to project your plan’s liabilities under a variety of scenarios.
Usually, you model your plan’s current asset allocation ﬁrst, while projecting how different scenarios could impact liabilities and funding needs of your plan over time. Then you can compare the current allocation scenarios to projections of alternate allocations that may better match your plan’s liabilities.
2. Choose an investment option lineup.
This will be based on the outcome of the asset liability modeling study and the asset allocation that best aligns with your plan. You, as the plan sponsor, and your financial professional are ultimately responsible for the investment selection.
3. Move to the new allocation systematically.
Once you’ve selected investment options, use a dynamic asset allocation (DAA) strategy to monitor and adjust to the new allocation over time. This glidepath can help determine allocation and de-risking as funded status improves.
Sample glidepath for a hard-frozen DB plan
With a DAA strategy, the pension plan allocates more assets to fixed income investments as the plan's funded status improves, as shown above. Investment gains are realized as they occur and then allocations shift to the fixed income side to reduce plan liabilities. This gradually reduces the portfolio risk.
How we can help
Considering an LDI strategy to help deal with market volatility in your pension plan? We can help you weigh your options.
Give us a call at 800-952-3343, ext. 22681.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
Investing involves risk, including possible loss of principal.
Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options.
Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline.
Insurance products and plan administrative services provided through Principal Life Insurance Co. Securities offered through Principal Securities, Inc., 800-547-7754, member SIPC and/or independent broker-dealers. Principal Life, and Principal Securities are members of the Principal Financial Group®, Des Moines, Iowa 50392.