Liability-driven investing: adding investment return, lowering risk; While still not wildly popular, so-called LDI strategies hold the promise of producing more optimal asset allocations for plan sponsors, resulting in lower plan cost, lower plan risk or a combination of the two.

• Author: Westerheide, Daniel F.
• Position: PENSIONS

Pension plan sponsors traditionally have invested plan assets, with varying degrees of success, by navigating the tradeoff between investment risk and reward, seeking maximum returns within acceptable volatility parameters. Now, however, prompted by equity market gyrations and changes in pension accounting and funding rules in recent years, portfolio strategists have been energetically talking up an alternative framework for defining investment "success" for pension plans: liability-driven investing (LDI).

So far, there appears to be somewhat more talk than action. Informal polls suggest that LDI strategies have been embraced by less than one-third of pension plan sponsors, although many more say they're giving it serious consideration. Indeed, the adoption rate is likely to rise as plan sponsors gain comfort with LDIs' merits and operation. The U.S. Department of Labor has sanctioned the approach as not contravening the plan sponsor's fiduciary duties by investing in a way that serves the best interests of participants.

Broadly speaking, LDI looks at the pension plan asset allocation decision through the wide lens of total plan risk and return. Specifically, LDI includes the plan's liability as a risk factor in the asset allocation-setting-process.

When one thinks about this view of total plan risk and return, it makes sense. After all, the financial impact of a pension plan on a plan sponsor's P & L, balance sheet and cash position is not simply driven by plan assets. Rather, the impact is driven by the plan's surplus or deficit--and surplus or deficit is the interplay of assets and liabilities.

Liability-driven investing does not prescribe a specific "solution." Instead, LDI focuses on the "excess return" of the plan's assets over its liabilities, and the volatility in that "excess return."

The Total Plan Picture

Since it's really the plan's actuarial surplus or deficit, not its assets alone, that drives the financial impact of the plan on the sponsor, that's what LDI looks at to construct its asset allocation strategy. As a result, the plan sponsor's financial risk in sponsoring the pension plan is reduced. Because of that perspective, LDI's proponents are working to persuade bond rating agencies that companies that stay on top of their pension liabilities should be rewarded with favorable grades on their debt offerings.

Analyzing pension liability risk--the first step in building a liability-based investing strategy--is driven by such factors as wage and consumer inflation, demographic risk and interest rate risk. By far the most significant component of liability risk is...