In recent years, many pension plan sponsors, trustees, and benefit committees tasked with overseeing the management of pension plan assets have taken a new perspective when thinking about the investment strategy and risk posed by their defined benefit pension plans (DB plans). This article addresses some recurring questions about the emerging strategies for managing investment risk for DB plans.

What factors have historically been considered when selecting an asset allocation for a DB plan?

In the heyday of DB plans, sponsors typically viewed an investment strategy through the lens of earning a “total return.” This was typically in line with the assumed rate of return on assets that the actuary used in their calculation of the DB plan liability. Taking on more risk allowed for a higher assumed rate of return on assets, which produces a lower DB plan liability (prior to the Pension Protection Act of 2006 [PPA], the DB plan liability was inversely correlated with the investment return assumption). This thinking still prevails in some plans today, in which sponsors may think of investing with a goal of meeting the “actuarial return.”

This thinking runs somewhat contrary to the Actuarial Standards of Practice (ASOP)¹ that underlie how the actuary sets their assumptions. Under ASOP No. 27, the actuary sets the assumed rate of return on assets based on the long-term expected returns of the asset classes in which the fund is invested. The investment allocation is set first based on the risk tolerance of the sponsor, and from that the actuary can determine the assumed rate of return on assets using long-term capital market assumptions for the selected asset allocation.

Under this approach, changes in the long-term expected return of broad asset classes may have an impact on the assumed return assumption (and thereby also on DB plan liability), even if the sponsor makes no change in the asset allocation. This has occurred over the past 10 to 20 years in which there were decreases in expected returns, particularly on fixed income (a trend that has seen a reversal in the last couple of years). In response to these changing long-term expected returns, many plans have reduced their assumed investment return assumptions. Other sponsors have sought out alternative investments to maintain the “actuarial return.”

The PPA brought changes in the IRS minimum funding requirements for single employer plans. These changes reduced the significance of the assumed investment return assumption for these plans as DB plan liability is no longer calculated based on the investment return assumption). Decoupling of the DB plan liability from the assumed asset return led to volatility in the DB plan funded status, which has prompted sponsors of these plans to consider ways to manage this volatility (and re-couple assets and liabilities).

How did the Pension Protection Act of 2006 change pension funding?

The PPA was major reform legislation aimed at securing the funded status of DB pension plans, with significant changes to the funding requirements, at least for a segment of the employer marketplace—single employer DB plans. They are DB plans that have a single corporate employer as the sponsor and/or fiduciary.

The PPA standardized the calculation of DB plan liability across single employer DB plans. Instead of the actuary setting reasonable assumptions for funding the benefit promise, the PPA mandated several key assumptions.

First, the PPA mandated the use of up-to-date mortality tables and prescribed how these tables would be updated in future years. This updated mortality assumption caused some significant increases in DB plan liability, as longevity had increased significantly since the 1980s and 1990s. Using a longer life expectancy causes an increase in the DB plan liability—as promised benefits are paid over a longer period.

Second, the PPA mandated that DB plan liability be calculated based on high-quality corporate bond interest rates. Effectively the benefit promise made by the company is similar in structure to a corporate bond. Under a bond, the company promises to make recurring coupon payments to the bondholder until the bond’s maturity. Under a DB plan, the company promises to make recurring benefit payments to the plan participant for their life. The PPA mandate harmonized the pricing of the DB plan liability with other types of corporate debt. A similar approach had already been undertaken by the Financial Accounting Standards Board (FASB) in how DB plans were accounted for on the company balance sheet (also using the yield of high-quality corporate debt to develop the DB plan liability).

After enactment, the DB plan liability was calculated based on published interest rates, regardless of how the plan was invested. This disconnect set the stage for a new way of thinking about DB plan risk.

What is liability-driven investing (LDI)?

Liability-driven investing (LDI) is a strategy that involves making investment decisions in the context of the purpose of those investments. The purpose of the DB plan investments is to pay for the promised benefits, in other words to cover a lifetime income stream of benefit payments to a group of plan participants.

LDI goes by other names, maybe most popularly known as asset-liability management (ALM). Regardless of the name, the concept is the same—make investments appropriate for their intended purpose, investing with an eye toward the plan liabilities (cash outflows).

Sponsors sometimes think of LDI or ALM as simply reducing exposure to equity risk and increasing exposure to fixed income. While this is part of the story, it is incomplete. Not all fixed income is created equal. In a proper strategy, the investor will consider the timing of the expected cash flows (duration) and attempt to match the duration of the fixed income investments with the duration of the cash outflows of the benefit payments. A plan that is completely funded with matched payments is considered fully immunized—the risk from the impact of interest rate changes on funding status has been mitigated to the extent possible.

It is important to note that some level of funded status volatility risk does persist, because there could be a default or downgrade among the fixed income investments held by the plan. If a corporation issuing debt defaults and fails to make the payments, a mismatch between the expected cash flows can be reintroduced. The plan sponsor and investment advisers will be actively engaged in monitoring the investments to reduce the impacts of this type of credit risk. In addition, because the benefit payments underlying the LDI strategy are not known with certainty—they are estimated based on the actuary’s assumptions—demographic experience can drive a deviation in the projection of these expected benefit payments that cannot be hedged with an LDI strategy.

How does this work under the PPA? Well, if a plan’s investment contains a portfolio of bonds that exactly matches the duration of the DB plan liability cash flows, then under the PPA changes in the yields of corporate bonds will have an impact on the DB plan liability. However, the plan’s investments will experience offsetting changes, keeping the plan’s funded status unchanged.

In an environment of falling interest rates, DB plan liabilities will grow (DB plan liabilities are inversely correlated to interest rates), but a fully immunized plan holding matching corporate bonds will see unrealized investment gains in its asset portfolio. If fully immunized, these investment changes perfectly offset the DB plan liability increases.

It is necessary to point out that there are alternative measures of DB plan liability other than those required under PPA. While the interest rates required by the PPA reflect the current interest rate environment, they still contain a level of smoothing (averaging of interest rates over time). The original law contemplated a 24-month averaging of interest rates. Subsequent funding of relief bills passed by Congress has expanded this smoothing to consider the 25-year average of interest rates. Because these smoothing mechanisms are not easily purchased in the bond marketplace, sponsors adopting an LDI strategy typically will benchmark their assets to a liability measure that lacks this smoothing, such as the FASB Accounting Standards Codification (ASC) 715 accounting liability or a measure of liability consistent with how an insurer may price the liability upon plan termination (i.e., a plan termination liability).

Equities historically outperform fixed income. Why choose investments that are expected to have lower returns?

This is the “total return” mindset that has been quite common for DB plans until recently. While it is true that, over a long time horizon, equities have (not to say this will always be true! Past experience does not dictate future results) outperformed fixed income, there is often greater year-to-year volatility along the way toward that outperformance. As an example, a plan may be forced to sell off its equity holdings to make benefit payments during a market downturn, which could lock in losses. Fixed income may provide a predictable pattern of income that can be used to pay benefit payments without the need of a sell-off at the wrong moment.

Under the PPA and financial reporting requirements from FASB, DB plan liability is tied to yields on fixed income. Investing in matching fixed income under an LDI strategy creates the situation for the sponsor to be less worried about the interest rate volatility—because the changes in plan assets will mirror the changes in DB plan liability. This is the perfect situation for a frozen plan, assuming the plan is fully funded. For an ongoing plan, this situation is also workable, but it does require continuing to make contributions to cover new benefit accruals earned by active plan participants.

For the sponsors of an underfunded DB plan, there is certainly the desire for the plan assets to outperform the interest rate used to measure the DB plan liability, which would improve the plan’s funded status. Fully immunizing (to the extent possible) an underfunded plan will permanently lock in that level of underfunding. The only chance to become fully funded under this strategy would be to increase the level of plan contributions. For underfunded DB plans, allocations to equities, while experiencing more volatility risk, as we note above, may provide longer-term returns and capital appreciation of assets, which could lead to funding level improvements. However, this is a risk that the plan fiduciaries must fully understand in managing the pension plan assets.

What is DB plan liability and how does it change?

DB plan liability is the present value of the expected benefit payments. There are two components to that statement:

• “Present value”
• “Expected benefit payments”

The “expected benefit payments” are determined by the plan actuary. The plan actuary collects a census of all plan participants and projects the expected benefits using a set of reasonable assumptions that are specific to the plan and its covered population. While these projections are subject to fluctuations if actual experience differs from the actuary’s assumptions, the actuary can reduce these fluctuations by performing experience studies and continually reviewing assumptions.

The “present value” relates to how these expected benefit payments are valued at the current point of time (sometimes known as the “time value of money”). For single employer plans, the DB liability is calculated by discounting using the yields on corporate bonds, as required under the PPA. For public and multiemployer plans, the DB liability is calculated by discounting expected benefit payments using an assumed return on plan assets.

Does plan funding status have an impact on a decision to implement an LDI strategy?

Yes! An LDI strategy is most effective in a DB plan that is well-funded. A DB plan that is not well-funded will have insufficient assets to deploy to the strategy. Thus, while able to match a portion of the plan’s overall liabilities, the strategy will not be able to fully immunize the DB plan’s cash flows (benefit payments). If an underfunded plan invests in an LDI strategy it cements its underfunded status—the only way to achieve an improvement in funded status would come from additional cash contributions (funding the shortfall). The DB plan will not be able to rely on potential excess returns to close the funding shortfall.

Instead, a DB plan that is underfunded can consider implementing a “glide path.” This strategy dedicates a portion of assets toward an LDI approach (either on the whole plan, on a subset of the plan, such as current retirees, or on short- to medium-term expected cash flows, such as the next five to 10 years of expected benefits). The rest of the plan assets are invested in a diversified portfolio including equities. The goal of a glide path strategy is that, as funding status improves (through excess returns on the return seeking assets), the investment allocation begins to gradually shift more of the overall portfolio toward the LDI strategy. This allows the DB plan to “lock in” improvements in funded status as they occur, slowly taking equity risk off the table as the plan approaches the ultimate funded status goal.

Do market factors have an impact on a decision to implement an LDI strategy?

Most certainly! An LDI strategy inherently involves shifting into fixed income investments. Fixed income investments are priced according to the interest rate environment in the economy. The higher interest rates become, the cheaper it is to buy a fixed income security (that is, the price of a bond decreases as interest rates rise). The opposite is true in an environment where interest rates are declining—a bond’s price rises as interest rate fall.

Thus, in an economic period of relatively higher interest rates, shifting into fixed income investments can potentially be done more economically, as bonds may be priced more competitively. Once a bond portfolio that matches the DB plan’s cash flows is acquired, then sponsors can be agnostic toward future interest rate movements—knowing that the changes in their assets and liabilities should offset one another to maintain the plan’s funded status.

For a DB plan with sufficient assets, even in a low interest rate environment sponsors may find value in “purchasing” the bond portfolio (i.e., changing the asset allocation into one with greater fixed income), because, following the purchase, future interest rate risk has been mitigated. Sponsors of public and multiemployer plans should be aware that the change in the plan’s investment allocation is likely to decrease the plan’s funded status initially, which is the cost of reducing the plan funded status volatility later. For single employer plans, where the DB plan liability is not related to the underlying investments, there is no immediate change in funded status. However, plan sponsors of single employer plans should be aware that the decrease in the expected return of the portfolio can have an impact on the accounting expense (net periodic pension cost), because a lower expected return on assets will give rise to an increase in the annual accounting expense.

What is a glide path and why might it be a suitable approach?

A glide path is a strategy used by some DB plans that are interested in employing an LDI strategy but are not yet sufficiently funded to fully immunize. In a glide path, the sponsors set funded status triggers in which they will increase (or decrease, in some cases) their asset allocations dedicated to the LDI strategy.

The assets outside of the dedication continue to be invested in a diversified portfolio that seeks to earn an excess return, which could improve the overall plan’s funded status.

The strategy is fully phased in at a sufficiently high funded status that sponsors consider to be “fully funded,” typically somewhere between 100% and 110%.

In some cases, the glide path will allow for “re-risking” events, which decrease the allocation dedicated to the LDI strategy if the assets outside of the strategy perform poorly and deteriorate the overall plan funding level below a trigger already achieved. This re-risking event allows for a plan to recover on its glide path after an adverse market event.

Is an LDI strategy a permanent change or can it be “undone”?

An LDI strategy is simply an asset allocation policy, in which assets are invested to mirror liability movements. Fiduciaries are free to change their asset allocations at any time, at their discretion, and an LDI strategy does not take away this flexibility.

A decision to move away from an LDI strategy should be understood to reintroduce the interest rate volatility risks that the adopters of the policy originally sought to reduce.

Why would I do LDI when I could invest in cash and earn x% return from now until plan termination?

Under plan termination, plan liabilities are priced based on market interest rates. While there is a competitive bidding process, the insurers that bid on the project will consider interest rate movements when determining the termination premium.

As discussed in this FAQ, interest rate changes can cause significant changes to the pension plan liability. One of the primary reasons for adopting an LDI strategy is to reduce interest rate volatility risk. The assets invested in the LDI strategy increase (and decrease) with interest rate movements, offsetting the pension plan liability changes. This creates a hedge on interest rate risk.

Investing in a stable value fund that provides a fixed, guaranteed return may seem like a low-risk proposition, but when those assets are backing a pension liability, it must be understood that the pension plan liability does not increase in a fixed, guaranteed manner—it adjusts to changes in market interest rates. Investing in this “risk-free” guaranteed return does not provide a hedge for the pension liability and creates funded status risk.

Suppose a pension plan is fully funded based on the current market interest rates (which let’s say for this example is 5%) as of December 31, 2024. The pension plan sponsor could invest in a stable value fund that guarantees 5% annual return. If market interest rates stay at 5%, then the guaranteed investment covers the expected growth in the pension liability. However, let’s review what occurs if interest rates decline to 4%. Even though the guaranteed investment is returning 5% per year, the decrease in interest rate impacts the pension liabilities. As an example, a mature pension plan may have a duration of 10 years, which means that the decrease of 100 basis points in interest rates gives rise to a 10% increase in the liability. The plan that was fully funded at 5% market interest rates is suddenly approximately 90% funded at 4% market interest rates.

Note that the guaranteed fund returning 5% will make progress in closing this funding gap over time if interest rates remain at 4% (assets will grow at 5% whereas liabilities will grow at 4%), but in the meantime the plan has lost its status as “fully funded.”

Having an LDI strategy here would have helped. By investing in a matching portfolio of fixed income that also has a duration of approximately 10 years, the assets would have also experienced a market value adjustment when interest rates decreased, keeping the plan fully funded.

How often should an LDI strategy be reviewed?

It is important to regularly review an LDI strategy, particularly while still on a glide path toward the full implementation of the strategy. These regular reviews allow a sponsor to identify when triggers are satisfied that would lead to shifts in the allocation. If the triggers are not reviewed regularly, opportunities to de-risk might be missed in the interim. Some sponsors have implemented quarterly, monthly, or even daily tracking of funded status to best find these trigger opportunities.

When the strategy is fully implemented, less regular reviews may be warranted. However, the strategy should continue to be monitored to avoid issues. This should be done at least on an annual basis, coinciding with the annual actuarial valuation. While certain economic risks can be hedged with an LDI strategy, other risks, such as unexpected changes in the plan’s demographics (e.g., mortality), cause changes in the plan’s funded status that will have impacts on the broader LDI strategy.

The plan sponsor must work closely with its actuary and investment consultant in implementing and monitoring the strategy for long-term success.

¹ The Actuarial Standards of Practice (ASOP) are professional standards for actuaries, and they collectively govern the work done by all actuaries. ASOP No. 27 provides guidance to the actuary in setting assumptions for measuring pension obligations like the investment return assumption. Section 3.7 of the revised ASOP No. 27 provides specific guidance, not limited to using the plan’s investment policy and the plan’s current assets as inputs in setting the assumption, showing that the direction for setting this assumption starts with the plan’s investment and sponsor risk tolerance, and not the other way around.