Liability-Driven Investing

Liability-driven investing (LDI) is a strategy employers use to reduce variations in the surplus of their pension plans and required employer contributions.

Almost a third (32 percent) of corporate pension plan sponsors are in the process of implementing or have implemented an LDI strategy, while another 18 percent are very likely to implement an LDI strategy, according to Clear Path Analysis’ report Pension Plan De-risking, North America 2015

However, LDI is not as prevalent in the credit union space as in the corporate pension world. By following the corporate pension world’s lead, credit unions can reduce the volatility in their defined benefit plan.

Surplus is the difference between the assets and liabilities in an employer’s pension plan. For example, if a pension plan has assets of $1 million and liabilities of $800,000, it has a surplus of $200,000. The goal of a liability-driven investing strategy is to reduce the volatility or variation of a plan’s surplus and, consequently, improve the predictability of pension expense and required employer contributions.

Many organizations like having a liability investment strategy because it helps them experience less volatility in their plan, and increases their ability to do solid financial planning.

LDI also helps protect the pension plan funded ratio (plan assets  plan liabilities) in stressed markets, like the recent credit crisis. The volatility reduction is typically accomplished by reducing the plan’s equity investment risk and by reducing the plan’s interest rate risk, which is the mismatch between the asset duration and the liability duration. Duration measures the sensitivity of an asset or liability value to interest rate changes.

Is LDI a Good Fit?

When deciding whether LDI is a good strategy to implement, take into consideration your current:

• targeted funded ratio of assets to liabilities. Every organization has an opinion about what funded rations is comfortable for them. For some, it’s 100 percent funded, while others may prefer to be more well-funded, like in the150 percent range.
• plan status, such as open (participants still accrue benefits) or frozen (participants no longer accrue benefits and liability growth is slower). Assets supporting frozen plans do not need to grow as quickly as those of open plans to keep up with the liability growth.
• contribution philosophy, such as always contributing the ERISA-required minimum or contributing to achieve a desired funded ratio. Contributions will accelerate asset growth and help keep pace with liability growth. Therefore, willingness and ability of plan sponsors to contribute will typically increase the viability of an LDI solution.

The ideal environment in which to implement LDI is a frozen plan whose funded ratio is above target. These plans have incentive to protect the funded ratio, and their liability growth is the easiest to mimic through LDI investments. However, other combinations of plan status and funded ratio can benefit from LDI as well, particularly if the plan sponsor has a desire to protect the current funded ratio and reduce plan volatility.

Implementing LDI

LDI is typically implemented through long duration bond investments and by reducing pension plan allocations to the equity(stock) market. Long duration fixed-income bonds will often have returns similar to plan liabilities, and therefore help to offset the pension plan’s total asset liability risk. Typically, LDI is put in place using a “blended” implementation. That is, many plan sponsors implement LDI for a portion of the portfolio, while maintaining robust traditional allocations as well. LDI implementation does not have to mean drastic changes to a CU’s current investment strategy. By turning over 10-30 percent of your portfolio to liability-driven investments, you can begin to experience the benefits of reduced volatility in your credit union’s defined benefit plan.

Shannon Eidson, FSA, CFA, is principal/investment consulting for CUNA Mutual Fiduciary Consultants. For more information about LDI, contact him at 800.356.2644, ext. 665.6453.