As pension plans aim to meet future obligations, liability-driven investing (LDI) seeks to use data to set a strategy that will more precisely match assets with liabilities and cash flow needs.
A key consideration that could become even more significant for LDI programs is the age demographics of the plan population, according to “How Old Is Your Pension Plan? Matching Pension Investing to Plan Demographics,” a paper by Nuveen Asset Management.
The main point of the paper, says Evan Inglis, a senior actuary in the institutional solutions group at Nuveen, is that the different parts of the plan’s liabilities have different characteristics. “Retirees are more predictable,” he tells PLANADVISER. “They are paid in the short term, and it’s easier to match assets to those liabilities.”
The clear relationship between retired participants and the liability they represent makes it an easy topic to raise with plan sponsors, Inglis says. “You can match assets to the retiree population so effectively,” he points out. “That’s going to capture the most basic impact and advantage of this approach: to avoid big retiree populations that aren’t well funded and are matched with assets.”
A retiree population that is large relative to the size of the company or government organization brings risk, Inglis explains. It creates a lot of risk, and demographic leveraging—using plan demographics as a factor in matching assets—occurs as the plan ages and evolves, and more retirees are part of the plan’s total number of participants. As an example, he describes a company with a billion dollars in revenue. “This company does not face a lot of risk from a $100 million pension plan if they’re 80% or 90% funded,” he explains. A company of that size would see making up $10 million or $20 million as small change.
Smaller firms—say, $100 million in revenue—will experience changes of that magnitude as a much bigger event, Inglis says. “Asset allocation will evolve to be lower risk as the plan matures and you get more retirees.”
Dave Wilson, managing director and head of institutional solutions at Nuveen, points to another advantage of using this strategy. “It goes very well with plan endgames, often an annuity buyout for the retirees,” he tells PLANADVISER. “The plan sponsor would be looking to transfer a portfolio of securities, high-quality bonds. If you’ve already developed an investment strategy to match against those liabilities, it will lower the cost of the transaction.”
It’s the active participants who present more of a challenge in LDI, Inglis explains. “The benefit payments will be made way in the future, and they are more challenging to match with bonds. It is much more difficult to make the match because of the long investing horizon.”
Since very few bonds mature beyond 30 years, Inglis says, payments are almost impossible to match precisely. At the same time, the active participants are still earning benefits, so the plan sponsor does not know what their ultimate benefit is going to be, or the type of benefit they’ll choose. “There’s lots of uncertainty in those benefits,” he admits.
The active liability is also quite sensitive to interest rate changes, the paper notes, because the expected payments are further in the future, which means that duration in the asset portfolio will help keep the assets aligned with the liabilities. At the same time, equities do not provide consistent duration and have not historically been correlated with pension liabilities.
“It is more challenging to reduce risk,” Inglis says. Because of the active participants, you’ll have a higher allocation to equities and more return-seeking assets, because risk reduction tactics are going to be less effective. “In combination with equities, you’re going to use some very high-duration assets: interest rate swaps, or futures, or Treasury STRIPs [separate trading of registered interest and principle securities].”
“Typically, equities have a very low correlation to pension discounting curves,” Wilson says, “and that correlation is very uneven. Equities have more volatility, so including Treasury STRIPs and long-dated derivatives helps to balance the equities portfolio, since these vehicles can dampen volatility.”
Another consideration for the active liability may be whether or not the plan is frozen: a fully funded and frozen plan does not need to achieve a high level of return. An open plan that intends to stay open and provide new benefits for years to come will benefit from an investment strategy that has higher growth potential.
A number of plans have a lot of risk, according to Inglis, because the plan size has grown, relative to the size of the operation. “They’re concerned about the increasing pension risk,” he says. In these cases, it might be a bit late to switch to this demographics-based approach, “but better late than never. Starting to implement this approach will definitely help the plan as the demographics continue to change.”
It makes sense to choose a strategy that effectively reduces risk, Inglis says, since risk reduction is so at the forefront of plan sponsors’ minds.
“How Old Is Your Pension Plan? Matching Pension Investing to Plan Demographics” can be accessed from Nuveen’s site.