Our Insights

February 2011

Pension Risk Management

David Druley and Michael Dunleavy

Asset management and investment banking firms across the globe continue to develop a variety of liability driven investing (LDI)–focused products and solutions for the pension plan community; however, there remains broad confusion over the meaning of LDI. While most of these products and customized solutions attempt to hedge liability-related interest rate and inflation risks, such hedging is only a piece, albeit an important one, of a robust LDI framework.

Cambridge Associates views LDI as a holistic risk-budgeting framework useful to many types of institutions in overseeing asset pools that support institutional liabilities. An effective LDI framework allows an institution to evaluate asset allocations and portfolio implementation in the context of its relevant liability and unique organizational circumstances and risk tolerance.

“An effective LDI framework allows an institution to evaluate asset allocations and portfolio implementation in the context of its relevant liability and unique organizational circumstances and risk tolerance.” 
A robust LDI framework seeks primarily to generate portfolio returns sufficient to fund the contractual liability and, in most cases, generate some excess return, but to do so in a risk-controlled manner. Theoretically, this framework will result in a more efficient investment solution and superior risk management, allowing institutions to better balance the potential rewards of higher returns with investment and organizational risks. LDI approaches focus on managing the relationship between the size of the asset pool and the related liability. This relationship is often referred to as surplus and the volatility of this relationship is referred to as surplus risk. The foundation of an LDI approach is assessing the sensitivities of the assets and liabilities to a variety of factors such as changes in interest rates, inflation, and a broad range of capital market environments. It also considers an institution’s financial health and the economic sensitivity of an institution’s operations or business.

A wide variety of institutions, including banks, insurance companies, settlement trusts, and pension plan sponsors, have used LDI frameworks. This paper focuses on the application of LDI frameworks to defined benefit pension plans, but the broad framework and strategies discussed can be adapted to effectively address asset-liability management for other retirement plans and institutions.

Surprisingly, relative to insurance companies and other institutions, pension plans have been rather slow in adopting LDI risk frameworks. However, over the past decade, the global pension industry has more widely embraced LDI due to changes across global regulatory regimes that sought to increase institutional transparency and force sponsors to maintain more fully funded plans. These changes required plans to value assets and liabilities using methods that more closely resemble mark-to-market measurement and, in most instances, also reduced smoothing mechanisms previously allowed in measuring plan assets and liabilities. Moving toward economic measurement of plan funded status resulted in greater volatility of reported funded status and thus increased volatility of periodic contributions, pension expense, and balance sheet measures.

Historically, many defined benefit pension plans employed a classic asset allocation strategy using asset-only frameworks where cash represents the theoretical zero-volatility asset class. For many institutions, including defined benefit pension plans, this framework ignores a large part of the risk equation—the risk relative to liabilities. Ignoring this risk leaves institutions inherently susceptible to sharp declines in equity markets. When accompanied by declining market-based liability discount rates, plans can find their asset values declining just as their liability values are increasing. The combination of sharp market declines and declining discount rates seen in the 2001–03 and 2007–09 periods resulted in a serious degradation of pension plan funded status. These events, which some have termed “perfect storms,” were neither perfect nor unlikely to occur. Although the timing of such squalls is always uncertain, historically they have occurred with some regularity.

Additionally, market declines that result in sizeable shortfall contributions often occur during periods of economic stress, when sponsors experience declining cash flows and have limited or expensive access to the capital markets. During these periods, increased contributions resulting from a decline in a plan’s funded status are particularly painful. Since plan contributions are typically contractual or legal obligations, the ramifications of not making required or planned contributions via operating cash flows or accessing the capital markets can have ominous consequences for the sponsoring entity. Regulatory changes over the past decade in the United States, Western Europe, and other parts of the world exacerbated the difficulty during these periods by shortening or eliminating the smoothing that was historically allowed in the calculation of a plan’s funded status and moving a plan’s surplus onto its sponsor’s balance sheet.

For these reasons, interest in LDI strategies has significantly increased. Many defined benefit plans have modestly adjusted their asset allocation and implementation based on LDI frameworks, yet few have fully employed more robust frameworks.