The 5 Myths: Myth No. 1, Liability Driven Investing

The 5 Myths Holding Back Plan Sponsors

Reallocating assets towards an LDI strategy not only limits potential investing opportunities, but also does not provide much of a safeguard from the impact on plan contribution obligations from poor market performance.

Myth OneLiability Driven Investing

The following case study demonstrates the risks of executing a “partial” LDI strategy.

    • Myth It is possible to significantly reduce risk with just a partial Liability Driven Investing (LDI) strategy.
    • Fact Even the best case scenario with a partial LDI strategy is only modest risk reduction.

A partial LDI strategy involves asset rebalancing to increase fixed income asset allocation to 45% (from 30%) with a duration that matches the liability duration, and to reduce equity allocation to 50% (from 65%).1

Using a hypothetical DB plan, fifteen percent of plan assets are reallocated to duration-matched fixed income (from equities). The analysis is based on 1,000 Monte Carlo simulations of equity returns and interest rates to determine how the plan’s funded status would change in 10 years. Lower end (10th percentile of plan contributions) captures scenarios in which a rise in equity markets and high interest rates positively impact funded status and lower contribution requirements. The upper end (or 95th percentile of plan contributions) reflects the bad outcomes (or tail-risk) in which a significant decline in equity markets and fall in rates negatively impact funded status and contribution requirements.

Impact of the Partial LDI Solution

Partial LDI modestly reduces pension risk at the upper end of projected range of contributions. Following table provides more details.
Range of required plan contributions over 10 years
Lower End Required Plan Contributions Upper End Required Plan Contributions
Current Strategy Partial LDI Current Strategy Partial LDI
$24 million $24 million $1,275 million $988 million

Current strategy:

  • 65% equities
  • 30% fixed income (Barclays Aggregate Index)
  • 5% cash
  • 95% funded status

Partial LDI:

  • 50% equities
  • 45% fixed income (Barclays Aggregate Index)
  • 5% cash

Notes: Analysis based on 1,000 Monte Carlo simulations of equity returns and interest rates to determine how the plan’s funded status would change in 10 years. Lower end (10th percentile plan contributions) captures scenarios where a rise in equity markets and high interest rates positively impact funded status and lower contribution requirements. Our upper end (or 95th percentile of plan contributions) reflects bad outcomes (or tail risk) where significant decline in equity markets and a fall in rates negatively impact funded status and contribution requirements. Source: Prudential Analysis

In the worst case scenario, a partial LDI strategy results in only modest risk reduction.

The results illustrate that this partial LDI strategy only modestly reduces pension risk. In a best-case scenario, for a plan with an initial funding status of 95%, the projected range of plan contributions at the lower end does not change because the plan is almost fully funded, while the upper end of projected range decreases by $287 million. Since the plan continues to have significant allocation to equities, risk reduction is modest.

In addition, LDI strategies leave sponsors exposed to longevity risk—or the risk that a plan’s participants will live longer than expected—resulting in higher benefits payments. While most plan sponsors have become more attuned to the investment risk that is inherent in their pension plans, longevity risk is a significant yet often ignored risk that cannot be addressed through investment strategy alone.

There is a potential solution for plan sponsors seeking to further reduce risk is to combine an LDI strategy with the purchase of longevity insurance from an insurer, which we address in depth in Myth 3.

REFERENCES

  • 1This definition of partial LDI is somewhat consistent with asset allocations reported in Milliman’s 2014 pension study (Milliman “2014 Pension Funding Study,” pages 4 and 5). Per the study, the largest plans have increased their allocation to fixed income from 28% of assets in 2005 to 40% in 2013, and have either attained their desired allocation or have not reached the next trigger point along their glide path to further de-risking.