When Aaron Meder first joined Legal & General Investment Management America (LGIMA) in 2010 as head of U.S. Solutions, the liability-driven investing (LDI) marketplace was still undeveloped.
Now CEO of LGIMA, Meder spoke recently with PLANADVISER about the early days of building out the firm’s LDI capabilities. Back in 2010, the firm had no external LDI clients, and Meder worked as a one-man team to build out new capabilities from scratch.
“I did that work for three years as more or less a solo team,” Meder recalled. “It was quite an exciting time, let me put it that way.”
After several years, Meder took an expanded role with LGIMA in London, first running the global LDI business and then becoming head of investments. When the opportunity came to move back to Chicago, his hometown, to be the CEO, it was obviously attractive for personal and professional reasons.
Meder said his own career path shows how quickly the topic of LDI has caught on among the firm’s pension plan clients.
“There was always a small group of investors that had been doing this sort of thing since the 1980s, when bond yields were really high,” Meder said. “There were perhaps one or two other providers that were active in this space back in 2010, but overall it still felt like a wide open marketplace and a great opportunity. The market was in the midst of trying to define what LDI even meant, and how to use the best practices in an efficient way.”
Not even a decade later, LDI has transformed, Meder said.
“The biggest difference, then versus today, is how complex and multifaceted LDI has become,” Meder explained. “Back then, we were talking about LDI as the idea of pension plans moving core fixed income holdings to longer-duration fixed income, and encouraging them to use a performance benchmark with a longer duration profile that more closely resembled a pension’s investment horizon, for example long government credit.”
Meder worked with a lot of pension plan clients on this approach, but over time the topic of LDI has steadily expanded to include much more sophisticated and customized solutions.
“Moving away from core fixed income is an important first step, but over the last 10 years, LDI has become much more about analyzing liabilities and responding to these,” Meder said. “We still run long credit portfolios, but we can also take another step and offer a truly tailored solution against a clients’ unique projected liabilities.”
According to Meder, LDI in today’s context can lead to more significant changes in pension investing behavior than one might imagine. It is reasonable to think the same might be true one day for DC plan investing.
“Especially as funded statuses has improved for pension clients using LDI strategies, we have seen them move from, say, 30% or 40% exposures in long-duration fixed income to 60% or sometimes even 80%,” Meder said.
LDI in DC plans
According to Meder, the use of LDI has mostly been confined to the pension plan market, but increasingly, LGIMA (and its competition) is thinking about how LDI could be of service to DC plans. Meder said the analog of defined benefit liability-driven investing on the defined contribution (DC) plan side is the discussion of “in-plan guaranteed retirement income.”
“So, on the pension LDI side, the objective is to have the liquid assets in hand when you need them to pay your pension liabilities,” Meder said. “It’s really kind of the same idea on the DC side—a successful outcome is about having sufficient money available when you need it and for as long as you need it. Pension plans are managing this goal for a whole population of people, while DC plans are serving individual account holders.”
One important caveat, Meder pointed out, is that LDI strategies must be informed by a plan sponsor client’s goals for the DC plan. In other words, an LDI approach will look different based on whether the DC plan is designed to be the main source of retirees’ income, or if it is supplemental.
“Full income replacement is not the goal of every DC plan,” Meder said. “Many are designed to be more supplementary in nature. The defining of goals is an important discussion to have when thinking about LDI, both for DB and DC plans.”
Practically speaking, in the near term, Meder said using LDI in DC plans could mean doing a reevaluation of the fixed-income investments offered. Just like DB plans have reconsidered holding a basic core fixed-income portfolio, which does not match their liability duration, and instead have embraced longer-duration fixed income, DC plan investors may consider doing the same, Meder said.
“Once you redefine what retirement income looks like, you start to redefine what the fixed-income portfolio looks like,” he added, “including in target-date fund glide paths. In my opinion, the next 10 years is going to bring a massive shift from core fixed-income in DC plans to something that looks more like LDI, just like we saw in the DB plan market.”
DC plans can address individual ‘retirement liability’
Another retirement industry executive focused on the topics of “DC LDI” and retirement income is Patrick Rowan, senior managing director, retirement income strategies and products, at TIAA.
Rowan’s background is in human resources, a fact that he says helps him understand the strains and stresses facing plan sponsors and participants. He worked at SUNY (the State University of New York) when he was in his graduate studies, then went to work for a chemical company as an HR supervisor in a plant in the Albany area. He eventually went back to SUNY as director of their human resources management system, and subsequently became director of HR university-wide.
“When you have run a retirement plan, you understand that people will lean on you to help them with the full end-to-end journey,” Rowan said. “At SUNY, a big issue was employee tenure and turnover, and trying to use the retirement plan to help people actually retire and to attract new talent. Working in this area showed me how moving into retirement is a major life decision and how it can be overwhelming for people. It is so important to have the right products and solutions in place.”
According to Rowan, one reason guaranteed income products are not prevalent in DC plans is because the regulatory and administrative infrastructure is not really there to support them—certainly not like it is in the 403(b) plan market.
“Until recently, the 401(k) was always looked at as supplementary,” Rowan observed. “Today, this has changed, and so I think the retirement income conversation will change quite rapidly. The whole retirement space is grappling with this change from accumulation only to addressing both growth and spending/income.”
From TIAA’s perspective as a provider of annuity products, Rowan said, it’s quite natural that the firm would see annuitization of DC plan assets as a pathway to LDI. Importantly, the firm advocates for partial annuitization with high quality institutionally priced products.
“It’s a common misconception that when you buy an annuity, this means turning your whole asset base into a guaranteed income stream,” Rowan said. “In reality, annuitization is flexible. We generally see a recommendation from advisers that only, say, 40% of the portfolio be annuitized as a means to address longevity risk and sequence of returns risk. This subtlety often gets overlooked.”
Hurdles remain to DC LDI
Context for this discussion is provided in a recent Issue Brief publication from the Employee Benefits Research Institute (EBRI), showing only a very small percentage of defined contribution and individual retirement account (IRA) balances are annuitized in a given year.
The research further shows a significant percentage of pension plan accruals have been taken as lump-sum distributions when the option was available. According to EBRI, the hesitation to annuitize retirement savings can leave individuals exposed to longevity risk and other challenges, such as uncertainty about how much one can spend monthly without risking running low on funds at some point during retirement.
“Some believe that cost is an issue,” the EBRI brief suggests, but researchers point out that not all annuities are expensive relative to other products or investment options. The Issue Brief points to deferred income annuities (DIAs) as an example of an annuity-type product that is designed to reduce the probability of outliving savings by providing monthly benefits only in the later stages of retirement.
“Because of their delayed payments, DIAs could be offered for a small fraction of the cost for a similar monthly benefit through an annuity that starts payments immediately at retirement,” EBRI’s brief says. “Many experts believe that the lower cost would at least partially mitigate retirees’ reluctance to give up control over a large portion of their DC and/or IRA balances at retirement age.”
The Issue Brief goes on to explore how the probability of a “successful retirement,” measured by the EBRI Retirement Readiness Rating (RRR), varies with the percentage of the 401(k) balance that is used to purchase a DIA.
“We find that, at current annuity rates, purchases of a DIA at age 65 deferring 20 years with no death benefits result in an overall improvement in RRR (for all ages of death combined) for DIA purchases equal to 5%, 10%, 15%, and 20% of the 401(k) balance,” the brief says. “However, there is an overall decrease in RRR for DIA purchases equal to 25% and 30%—due in part to the interaction with long-term care costs. If a pre-commencement death benefit is added to the DIA, there is an overall improvement in RRR for DIA purchases equal to 5%, 10%, and 15% of the 401(k) balance.”