Pension & Investments Article

Interest among US pension plan sponsors in Liability Driven Investing will reach a "tipping point'' within five years, with the development of more sophisticated strategies paving the way for near universal acceptance, a new report from Russell Investments predicts. That will happen despite short-term obstacles thrown up by the market trauma of 2008. For example, the severe underfunded status of many pension plans now will make it more difficult to aggressively implement an LDI program over the next year or so. Likewise, market mayhem will temporarily damp demand for essential hedging tools such as swaps, while setting back the development of pension buyout markets that had been picking up steam in countries such as the United Kingdom. In the end, the psychological impact of the market maelstrom that corporate pension sponsors are living through now will outweigh such short-term obstacles to LDI, predicted Robert Collie, director of investment strategy with Russell.

Mr. Collie said 2008 "is going to be one of those years which permanently changes the psyche of the people who lived through it,'' resulting in a generation of pension plan executives who will "see the world differently.'' At present, LDI is the "foundation'' for the investment strategies of perhaps 20% to 25% of US pension plans, and their experience over the past year is shaping the ongoing development of efforts to better match assets and liabilities. Part of the fallout from the past year's market fireworks will be a broadening of the scope of the risks LDI programs are designed to hedge against, moving beyond the preoccupation in recent years on interest-rate risk. For example, the mismatch that occurred between the valuations of the Treasuries anchoring many LDI programs and the high-grade corporate bond yield used to calculate the current value of future pension obligations has led to a much greater awareness of the need to take credit risk into account. Over the past year, investors seeking a safe haven have poured money into Treasuries, leading to higher prices and lower yields, while fleeing corporate bonds, which led to lower prices and higher yields. As a result, pension funds with LDI programs that added to their Treasury holdings have enjoyed an unexpected gain, as the value of their assets jumped while rising corporate rates slashed their liabilities. In effect, while LDI programs have failed to match assets and liabilities, they've done so in a way that has favored those pension plans - a lucky break. Still, the understanding that things could also have moved in an unfavorable direction has hammered home the point that "tactical considerations'' cannot be ignored, and a number of plans have taken steps to lock in the gains they've enjoyed.

Other risks that have come to the fore as a result of the past year include counterparty risk, which has lowered demand for swaps, and immunization schemes, such as pension buyouts. Underlying market demand will ensure that the current setbacks are temporary, even if the exact path for the development of key LDI components can't be sketched out with certainty today. It's clear that 20 years from now, there needs to be a long-term solution for companies that have frozen their pension plans and require a more cost-effective way to manage those assets than retaining an in-house staff, he said. Within three to five years, Russell officials expect depleted pension funding levels to have recovered, either by a rebound in equity markets or the significant contributions required under PPA. At that point, this battle-scarred generation of pension fund executives will begin implementing LDI programs in droves. Then, with 50% or more of pension plans adopting LDI programs, the herd mentality will kick in, and it will be a very short distance "from tipping point to game over."