Liability Driven Investing in Pension Plans

By Mark Johnson, J.D., Ph.D.


Pension plan administrators with responsibility for defined benefit plans are reducing their exposure to the equity markets by using more predictable investments, such as bonds, to fund future obligations. An increasingly popular investment technique to match plan assets with liabilities is known as “liability-driven investing” or LDI.


LDI is a structured investment program designed to finance a predictable stream of future payments. In the case of defined benefit pension plans, for example, plan participants are scheduled to receive known future pension payments based on length of service, salary, and other factors.


The appeal of a liability-driven investing program to a plan administrator (as well as the Board of Directors and Chief Financial Officers of the sponsoring company) is the ability to reduce or hedge risk by aligning investment programs with future promises to plan participants.


There is actually some disagreement among industry leaders on the exact definition of LDI, according to SEI’s 4th Annual Poll on liability driven investing released in December 2010. “A portfolio designed to be risk managed with respect to liabilities,” is the top LDI definition in SEI’s latest poll, as compared to an earlier favorite of “matching duration of assets to duration of liabilities.”


Large Defined Benefit Plans Adopt Liability-Driven Investing


Hewlett-Packard Co., with $36 billion in retirement assets, has adopted many LDI strategies, according to a June 2011 article in Pensions & Investments magazine. The company successfully structured an LDI program for a defined benefit plan that was frozen in 2007. After assuming responsibility for an underfunded plan in its 2008 acquisition of Electronic Data Systems Corp., HP is gradually moving toward 100% funding levels with a strategy to adjust equity allocations.


Liability-driven investing strategies in use by pension plans increased by over 35% between 2007 and 2010, according to a 2011 report by Booz & Company. Additionally, the report states that 77% of large defined benefit plans ($1 billion or more) intend to increase their allocations to LDI strategies.


LDI Portfolios Allow a Choice of Assets


Plan administrators rely on investment managers to suggest specific financial investments that will meet pension obligations. Typical LDI investments include U.S. Treasury bonds, high grade corporate bonds, interest rate swaps, derivatives, and other hedging techniques. The traditional portfolio weighting concept of stocks vs. bonds is replaced in LDI with risk vs. returns.


Structured portfolios with better predictability are seen as an alternative to heavy dependence on equity markets, which have been extremely volatile in recent years. However, fixed rate investments such as bonds also carry risks in an environment where long term interest rates are likely to rise from today’s historic lows.


Regulatory Changes Drive LDI Initiatives


The adoption of liability-driven investing strategies is driven in part by recent industry and regulatory changes intended to both shed light on pension obligations and strengthen future funding levels.


The Pension Protection Act of 2006 required that all defined benefit plans subject to Title IV of ERISA furnish an annual funding notice to the Department of Labor’s Employee Benefits Security Administration (EBSA). These annual notices must include the plan’s funding percentage. Single-employer plans must report their “funding target attainment percentage” and multi-employer plans must report their “funded percentage.” Guidelines for the valuation of plan assets are also established. The PPA has changed the funding horizon of defined benefit plans from a long term perspective to funding 100% of current liabilities of an annual basis. This shift makes plan sponsors much more sensitive to market volatility.


On a related note, the Financial Accounting Standards Board (FASB) issued FAS Statement No. 158 in 2006. Titled “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” the statement amended earlier FASB guidelines.


Overall, FAS 158 is intended to “improve financial reporting by requiring an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multi-employer plan) as an asset or liability in its statement of financial position …” The Statement also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions.




Growth of liability-driven investing is expected to continue in the U.S., since it is viewed as an effective way to fund closed or frozen defined benefit plans.


ABOUT THE AUTHOR. Mark Johnson, Ph.D., J.D., is a highly experienced ERISA expert. As a former ERISA Plan Managing Director and plan fiduciary for a Fortune 500 company, Dr. Johnson has practical knowledge of plan documents as well as an in-depth understanding of ERISA obligations. He works as an expert consultant and witness on 401(k), ESOP and pension fiduciary liability; retiree medical benefit coverage; third party administrator disputes; individual benefit claims; pension benefits in bankruptcy; long term disability benefits; and cash conversion balances. He can be reached at 817-909-0778 or www.erisa-benefits.com.


ERISA Benefits Consulting, Inc. by Mark Johnson provides benefit consulting and advisory services and does not engage in the practice of law.


September 2011



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