One current DB trend is liability-driven investing (LDI), in an attempt to match assets to future benefit obligations. Is there a way for DC plans to make use of LDI?

The shift in focus for DC participants from accumulation of assets to understanding how those assets can produce reliable income in retirement has been a growing topic for the past five to 10 years, says Bob Schmidt, manager of the Brandes Institute. “The aging Baby Boomer population is putting more emphasis on the issue, with 19,000 turning 65 every day,” he tells PLANADVSIER. “How do you generate income for these folks?” But how to guarantee income within a DC plan is still uncertain.

Schmidt points out it can be very hard for people to conceptualize the best way to handle an accumulation of retirement assets. “People get used to receiving a paycheck once or twice a month,” he says. “Then suddenly: ‘Here’s your lump sum. Manage that for the rest of your life.’ “

In theory, LDI makes tremendous sense, Schmidt says, since the strategy is used as a way to balance assets against future needs. “That said, there are some practical issues that make it tough to implement,” he notes. First, it’s very difficult for individuals to accurately forecast how much money they will actually need in 15, 20, 30 or 40 years.

Schmidt points out a number of macro assumptions to consider, such as inflation or how long someone’s lifespan might be, which cannot be predicted with certainty. People also need to factor in housing costs, possible medical needs (another area that is difficult to forecast accurately), or the wish to share money with children or grandchildren to help with college tuition or a home purchase. “An unforeseen medical need or family issue may significantly alter income needs in retirement,” he says.

“You don’t have the pooling of assets and the pooling of longevity risks” in a DC plan, Schmidt points out, so it is possible a hybrid approach that works along a combination of factors, is called for. “Some kind of income security and some kind of asset maximization,” he says. “You might have a portion of assets in an immediate annuity and the remaining in stock, corporate bonds, real estate and other asset classes. So you’re looking for inflation-fighting protection of capital appreciation investments like equities, and complementing it with some kind of income-producing product, like an annuity.”

Schmidt says the biggest concern with using DC investment options to create an LDI strategy is cost. Combining strategies is best, he feels, because it helps balance pros and cons. “You can get income security now, but with interest rates at record lows, you’re going to pay a lot,” he says. “Thinking interest rates will remain low is not a realistic assumption. If they go up, people will leave a lot of money on the table. If interest rates were at 7% or 8% that would change the discussion quite a bit. But that’s not the case.”

As the purpose of LDI is matching assets with liabilities, using it in a DC plan would mean taking out money at pretty low rates, explains Bruce Grantier, the now-retired managing director of pension assets at Scotiabank. “Structurally, it would work,” he says. “But practically? Now is not a great time.”

Grantier says plan sponsors can consider a fixed-income oriented fund with a long duration--or whatever duration is appropriate for when participants retire. “The duration, based on life expectancy, is like a long bond,” he says. “You could have a target-date LDI. If you retire at 65 and are going to live another 20 to 25 years, you’d move from the equities to more fixed income.”

Bond options within a target-date fund (TDF) are one possibility for plan sponsors to consider, Grantier says. This approach is used for a mix of bonds and equities, but it can be used to lock in retirement income. Alternatively, an all-bond fund could be used.

Schmidt is a believer in the stock market for long-term gains. Annuities are the obvious product to generate a guaranteed stream of income in retirement, but he feels there are other opportunities that will continue to generate wealth and produce income, like equities. “These should be a core component to get you not just to retirement, but through it as well,” Schmidt says.

Investors became jittery as the stock and real estate markets pulled back in 2008 and 2009, he notes, and became less willing to depend on them. “People were looking too much at the short term,” he says. “In a lot of places, the real estate market has bounced back. The stock market has come back, and exposure to appreciating assets like equities is a great source for retirement plans.”

Some investors may want to limit price volatility of plan assets in the short term, Schmidt says. “Some may be concerned with mark-to-market accounting rules and funding levels,” he says. “But these types of short-term considerations may drive investment decisions that are at odds with longer-term needs.” 

An example in the context of LDI would be that investors struggle with the best way to build a portfolio of assets to meet their liability needs decades from now.  “In the short term, stock prices can be volatile—and a reluctance to accept these inevitable bouts of volatility may prompt investors to load up on bonds and minimize exposure to equities,” Schmidt says. “But we think that’s the wrong approach. We remain convinced that stocks represent one of the best asset classes to help investors reach their long-term goals and deserve a seat at the table, even within an LDI framework.”

If LDI as a concept helps people to focus on the income they’re going to need in retirement, Schmidt feels that is terrific. “That is the goal of retirement planning,” he points out.