LDI Strategies Help Cover Future Liabilities

July 21, 2008
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Most pension, workers’ compensation and health care plans invest their assets in the financial markets, but the financial markets aren’t as accommodating as they were a decade ago.

Pension plans, in particular, have been affected by volatile markets, lackluster interest rates and increasing corporate regulation, according to Fifth Third Asset Management.

For the companies, government units and organizations that sponsor pension, workers’ comp and health care plans, the ability to adapt to changing economic and market conditions is critical to liability funding.

The traditional approach to pension investing looks almost solely at the risk-and-return characteristics of a plan’s assets, according to Fifth Third. An LDI (liability-driven investment) strategy approaches the problem by identifying liability streams and matching those streams with incoming cash flow from investment assets. Such a strategy could be an effective approach for assuring that future liabilities are fully funded and covered, said Mitch Stapley, chief fixed income officer for Fifth Third Asset Management.

“Instead of focusing on the asset side of the liability equation — be it a pension liability or a health care liability — you really need to be focused on what your liabilities are, how your liabilities are going to grow, and what you can do to match assets up to your liabilities,” Stapley said.

“Instead of talking about the assets and the performance of the assets, you’re talking about the liabilities and what you have to do to meet the liabilities. When you turn the question upside down on its head a little bit like that, I really think you create a more useful process.” 

A company needs to work with an actuary to identify the present value of the liability stream it has today, he said. An actuary can tell the company how much money it has to be set aside over 10 years to cover the claims it can expect to see 10 years down the road.

Stapley said the LDI concept hasn’t caught on as quickly as he had anticipated it would since Fifth Third introduced it four years ago. He said a lot of it has to do with the overall term rate of interest out there right now, because low interest rates make an LDI program harder to implement. However, LDI strategies are bigger in Europe where there are pension laws that require companies to fund their liabilities with more certainty and use more assets like long-term, high-quality government bonds, Stapley pointed out.

In the United States, interest rates have been relatively low for the last four years, and that has negatively impacted many pension plans because lower interest rates bump up the present value of their future liability stream.

“If you expect your health care liability to grow by 8 percent, and you get a 5 percent interest rate on a zero coupon treasury, you have a 3 percent funding gap that you have to make up somewhere,” he noted.

“We’ve had a period of pretty good returns in the stock market over the last couple of years, so some people have been funding their plans the old-fashioned way with stocks.”   

As Stapley pointed out, there have been legislative changes in terms of pension loss that basically make something like a liability-driven investment policy a lot more attractive. Regulatory changes have made the funding of pension plans even more challenging.  Since December 2006, the Financial Accounting Standards Board has required that companies post the present value of a plan’s assets versus its liabilities on balance sheets rather than in footnotes.

Additionally, the Governmental Accounting Standards Board now requires state, county and local governmental units to disclose the conditions of various pension and other post employment benefit plans. That’s a huge change, Stapley said.

A lot of state and municipalities have been meeting their retiree health care and pension obligations out of current operating funds on a “pay as you go” basis. That tactic had dire consequences for the city of Vallejo, Calif.

The Vallejo City Council voted in early May to declare bankruptcy because the city couldn’t fund its police and fire pension and health care obligations. Vallejo was paying more than $170,000 a year, for instance, in total compensation to its average firefighter.

“There are a lot of states and municipalities out there that don’t have a pool of assets set aside to fund their retiree health care and pension obligations, which can be in the billions of dollars,” Stapley noted.

“That’s just frightening, but that’s the case of a lot of cities in Michigan. Potentially, those municipalities could issue some kind of a pension funding bond deal, go out and get the money and invest it in an LDI strategy.”  

The required adoption dates for the GASB standards are based on the fiscal year 2000 revenues of the governmental entity. The effective date for government entities with year 2000 revenues of more that $100 million  was Dec. 25, 2006; for government entities with fiscal 2000 revenues of $10 million to $100 million, it was Dec. 15, 2007.

Government units with fiscal 2000 revenues of under $10 million must comply by Dec. 15 this year.

Stapley said an LDI strategy takes a lot of uncertainty out of financial decisions, and that with such a strategy, a company or municipality won’t experience big swings in income because of a shortfall in the pension funding ratio.

“The thing to keep in mind is that every one of these portfolios is unique and different because everybody’s liability streams are unique and different.” HQX

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