What does Kenny Rogers have to do with pension plans? Well, nothing really. But as I sat down to write my LDI blog post, I thought about how many plan sponsors gamble with their pension plan investments.
As I mentioned in earlier posts, the behavior of the stock market has little to do with the way a defined benefit (DB) plan’s liabilities react. Yet many DB plan sponsors make big bets by allocating a large portion of their plan portfolios to stocks— without considering plan liabilities. (After all, “You’ve got to know when to hold ’em, know when to fold ’em.”)
Over the past five years, several factors—such as changing legislation, a volatile stock market and low interest rates—have created mismatches between DB plan assets and liabilities. These mismatches have created significant funding volatility for plan sponsors.
Liability-driven investing may help
One way to help reduce this risk and volatility is to better match a plan’s assets and liabilities. This is called liability-driven investing (LDI).
LDI aims to invest plan assets in investments of durations similar to that of the plan’s liabilities. This is typically done by investing in long-term bond funds. The goal of LDI is to allow plan assets and liabilities to react similarly to interest rate changes.
Typical concerns of plan sponsors about LDI include:
- Downside risk. Some plan sponsors worry about the potential of locking in losses if they invest in long bonds today and then interest rates begin to rise.
- Missing the upside. The other concern is the inability to fully realize upside potential if the stock market has strong performance.
Strategies to help overcome concerns
One common strategy to address these concerns is to move gradually to an LDI strategy over time as interest rates increase. Another strategy is adopting a dynamic asset allocation approach (also referred to as a “glide path”). This strategy can help take the emotion out of investment decisions. I’ll discuss these ideas further in my next post.
The interest level of LDI investment strategies with DB plan sponsors has risen dramatically over the past 12 – 18 months. I guess the biggest question plan sponsors have to answer as they consider LDI is whether they know when to walk away…and know when to run.
In addition to blogging here, I also tweet regularly about DB topics of interest. Click to follow me on Twitter- @scottruba.
Asset allocation/diversification does not guarantee a profit or protect against a loss. Use of DAA and/or any glide path does not guarantee improvement in plan funding status nor the timing of any improvement.
While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that none of the member companies of The Principal are rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
Insurance products and plan administrative services are provided by Principal Life Insurance Company a member of the Principal Financial Group® (The Principal®), Des Moines, IA 50392.