How Is Liability-driven Investing Different?

By Jeff Chang

The more you read about what has been going on in the private sector (in the U.S.) and in the public sector (in Europe) with respect to pension plan investing, the more you come across the concept of “liability-driven investment strategy.” Although there are many ways to describe LDI, a good starting place is the notion that LDI attempts to manage plan assets and risks in relation to plan liabilities. By contrast, many pension plans, particularly in the public sector, still utilize a so-called “benchmark-driven strategy” – one which aims to equal or beat a pre-established rate-of-return on plan assets using a target asset allocation model (such as a 60 percent/40 percent portfolio). What are some other differences between these approaches, and how might they be important to the success of public pension funding, OPEB funding, and individual retirement planning? 

There is an abundance of scholarly and hyper-technical explanations of LDI. I will not attempt to summarize or explain the details of LDI in this limited space. Rather, let me highlight the main differences in LDI and BDI through a series of simple observations.

Observation #1: Traditional BDIs assume very long investment horizons. For example, a typical BDI-based investment policy statement will include references to obtaining return targets “over the long term” or the use of a “long-term investment horizon.” Often, these time horizons are not defined, nailed down or even discussed with the plan fiduciaries. Basically, they rely on observed historical rates-of-return for various asset classes (e.g., stocks, bonds, real estate, etc.). However, we have seen such time horizon references in IPS’ for defined benefit pension plans that the employer planned to terminate within a few years. An LDI-based IPS would focus explicitly on the projected plan liabilities for the terminating plan, the number of years before the termination occurs, the current funded status of the plan, and how — through a combination of employer contributions and plan investments — the plan would be in a position of having sufficient assets to terminate as of the termination date. As a result, an LDI–based approach likely would become much more conservative as the target termination date and the level of desired funding are gradually attained. LDI is not the “open-ended” approach to investing that BDI can often be. BDI is often characterized by the notion of “staying the course,” while LDI is much more adaptive and flexible.

Observation #2: An LDI approach forces us to examine our investment and funding assumptions on an ongoing basis – and to make adjustments. Because an LDI approach starts with an identified liability or funding target, compares it with the current value of available assets and challenges us to figure the best way to achieve that goal, it makes us carefully evaluate the assumptions we have made as part of our plan. For example, your individual retirement strategy might state that you will need a specified amount of retirement savings within a specified number of years. Of course, some of the key assumptions that need to be made are: the amount of savings you are starting with, how much you are contributing (or funding) toward this goal and the assumed or expected rate of earnings on your savings. Obviously, if your earnings assumption is too high (compared with actual earning experience), you will not reach your goal unless you contribute more money (than you had planned) or you delay your retirement date, or both. What happens if you can’t afford to put any more money in? It’s simple: all you can do is reduce your retirement benefit and/or delay its payment.

So, how does this pertain to your city or special district? If you are in CalPERS, a county retirement plan or maintain your own defined benefit pension plan, you clearly have one form of large unfunded liability. If you also provide retiree health benefits, you have, or are creating, another form of unfunded liability. The questions are: Are you in a good position to satisfy these liabilities and, if not, what are you going to do about it? The fact that you are riding along with many other employers on the CalPERS “bus” doesn’t change the fact that you have liabilities, costs, revenues and labor obligations that exist, in many respects, separate and apart from the overall funded status of CalPERS and its “long-term” plans to correct its overall funding. Despite one of the most robust bull markets in history, CalPERS is still projecting steadily increasing employer contributions for the next decade. What happens if your agency simply can’t wait 20 – 30 years for its contributions to return to a more sustainable level? It is becoming more and more clear that the CalPERS bus is attempting to change its course, and slowly adapt to a more LDI-based strategy. The problem is that your agency and its employees may (when focusing solely on your liabilities and assets) have run out of time and/or money.

Jeff Chang is a partner at Best Best & Krieger LLP. He has four decades of experience skillfully evaluating benefit and retirement plan compliance to achieve maximum outcomes for public agency clients throughout California. He can be reached at jeff.chang@bbklaw.com or (916) 329-3685.

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