The idea that pension plan asset allocation should be tied to funded status is surprisingly young. It was not common practice before 2008. In April 2009, when we wrote a paper called “Liability-Responsive Asset Allocation,” it was (as far as we are aware) the first time that this approach was formally described in any detail. Just five years later, it’s taken as a given. Nobody is surprised when the financial statements of major corporations talk of “a broad global pension de-risking strategy” or note that a pension plan’s “interest rate hedge is dynamically increased as funded status improves.”1
Two developments together acted as the catalyst for this change in the industry. The first was that more and more pension plans began freezing new benefit accruals. For a frozen plan, investment returns become less important once full funding is achieved. If there’s already enough money in the plan and no new benefits are being accrued, then there’s not much to be done with any additional returns that might be earned. The obvious route of turning them over to the plan sponsor comes with a hefty tax bill attached.
LRAA Best Practices
An LRAA policy should specify with more granularity the breakdown of assets within the categories “return-seeking” and “liability-hedging.” All glide paths specify the balance between return-seeking assets, such as equities, and liability-driven investing (LDI)/hedging assets, such as long-duration corporate bonds, depending on the plan’s funded status level. But planning needs to go further.
As a plan moves down its glide path and the size of the return-seeking portfolio shrinks, diversification of these assets may become harder to achieve, so the make-up of the portfolio may need to vary. Asset illiquidity may become more of an issue over time. Similarly, within the LDI portfolio, there may be little value in fine-tuning the hedge to the liabilities when the plan is at the return-seeking end of the glide path and allocation to LDI is a small portion of the total portfolio. At this early stage, the most important goal of the LDI investments is to respond to interest rate changes—i.e., to increase the duration of the portfolio as interest rates rise. But when the hedging portfolio accounts for a larger proportion of the plan’s total assets, the plan sponsor should consider more closely tying the hedge to the liabilities, focusing on credit spreads and key rate durations (KRDs), for example.