Taking volatility out of your organization’s defined benefit plan using an LDI strategy
Volatility causes headaches for anyone managing a defined benefit (DB) plan. From interest rate changes, mortality table updates, PBGC premium increases and basic fluctuations in the market, it can be challenging to ensure that you can meet the plan’s benefit payment obligations to participants.
While no one can prevent defined benefit plan volatility, there are ways to help manage it—while also maximizing your return on DB plan investments.
One option to consider is creating a liability-driven investing (LDI) strategy.
LDI tends to be better at managing volatility than other strategies, like those simply focused on maximizing their investment return (aka “total return” strategy). While total return strategies aim to increase assets according to peer benchmarks, LDI helps manage your assets in alignment with your plan’s specific future liabilities.
In addition to helping manage volatility, LDI may also help:
- Limit excessive upside or downside risk
- Provide enhanced fiduciary oversight of investment allocation decisions
- Generate higher expected “real” returns over time
- Reduce accounting expense
The overall goal of an LDI strategy is to review your DB plan’s liabilities and invest the plan’s assets so that they react similarly when interest rates change. It works by matching the duration of a plan’s assets with its liabilities. 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 the LDI strategy for your plan could involve several durations. With this tactic, you’d create different “buckets” of duration depending on your organization’s employee make-up and when the corresponding liabilities are due. Your fixed income investment strategy would then match these “buckets” with bonds of a corresponding duration. For instance, younger employees would have a longer duration than older employees.
Setting up your LDI strategy
If you decide that an LDI strategy is right for you, there’s a 3-step process to set it up:
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, the plan’s current asset allocation is modeled ﬁrst. This projects how different scenarios could impact the plan’s liabilities and funding needs over time. Then you can compare the current allocation scenarios to projections of alternative allocations that may better match the 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, along with your investment adviser, are ultimately responsible for the investment selection.
3. Move to the new allocation systematically.
Once you’ve selected your investment options, you can use dynamic asset allocation to monitor and adjust to the new allocation over time. A dynamic asset allocation strategy creates a glidepath to get from today’s allocation to where you want the allocation to be. This glidepath can help dictate the allocation and the de-risking as funded status improves. The chart below shows an example.
Sample glidepath for a hard-frozen defined benefit plan
With a dynamic asset allocation strategy, the pension plan allocates more assets to fixed investments as the plan's funded status improves.
With this strategy, any investment gains are realized as they occur and shift to the fixed income side to reduce plan liabilities. This gradually reduces the risk of the portfolio.
We can help
Considering an LDI strategy? You don’t have to do it alone.
Principal can help you and your financial professional weigh your options—including understanding bond fund duration and its long-term effects on various strategies. To learn more, give us a call at 800-952-3343. ext. 22681 or contact your advisor.