Under GAAP accounting rules, plan sponsors of defined benefit (DB) pension plans must recognize the plan’s funding deficit on the company’s balance sheet. This wouldn't be so bad if it weren’t so difficult to match plan assets to plan liabilities. Unfortunately, DB plans are consistently challenged by volatile interest rates and equity markets. While achieving a precise asset to liability match is difficult in the best of times, it is extremely challenging during periods of volatility.
Many plan sponsors use traditional liability-driven investing (LDI) strategies. However, because the pension payments are paid monthly over a very long period and the pension liability is measured annually based on specific corporate-bond rates, matching assets to liabilities is not an easy task. As those corporate-bond rates move, the liability moves as well. The plan assets not only need to deliver the monthly cash flows to pay benefits, they also have to match the movement in the value of the liability as closely as possible. Traditional best-efforts LDI strategies have had trouble with that precise matching, which results in tracking error.
Asset managers will say to a plan sponsor that they “cannot buy the curve.” They’re referring to the Citi Pension Discount Curve (CPDC) that's used by many actuaries and plan sponsors to measure plan liabilities. It's a nearly impossible task for an asset manager to buy and hold the same bonds and allocation used to develop the monthly CPDC.
Even if an asset manager could hold all the bonds in the CPDC, it may not be a suitable investment for a pension plan because of the heavy concentration by industry and by issuer of the bonds used in the curve. This concentration increases the downgrade and default risk of the investment portfolio, and thus may not meet the diversification requirements of the plan's investment policy. If a bond is downgraded or defaults during a month, it is simply taken out of the CPDC in the following month. Thus, the CPDC never suffers losses from downgrades or defaults. However, a traditional LDI portfolio that actually purchased those bonds that were later downgraded or defaulted would suffer a loss.
An alternative to traditional best-efforts LDI could employ the services of an insurance company, because an insurance company can guarantee1 the published rate curve precisely (i.e., mimic the CPDC) and promise to return the same benefit payments as the plan actuary measures when determining the GAAP liability. By employing this approach, an insurance company could “mimic” the curve and create an insured LDI strategy. This would result in no bond credit risk (no downgrades or defaults) and no interest-rate risk. As a result, there would be no tracking error. No matter how the yield curve changes from month to month, the guaranteed or insured LDI strategy will match the plan’s projected liabilities; and thus, the plan’s funded ratio will remain stable, and balance-sheet volatility would be reduced.
Financial executives and their Boards of Directors spend a significant amount of time trying to understand complex traditional LDI strategies, comparing actual results to expected results and reasons for the variances. By transferring this responsibility to an insurance company that offers an insured LDI strategy, those decision-makers can turn their attention back to the core business.
Of course, this insured strategy must provide flexibility so plan sponsors can adapt it to their needs. For example, this strategy could be implemented on a partial basis, such as stabilizing only the retiree liability. Also, the plan should not be locked in to the contract so that a plan sponsor can exit the contract completely with no penalties or surrender charges. In this way, transferring the liability to an insurance company could provide cash flow for retirees and remove the stress from the plan sponsor despite volatility in interest rates.
1Guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company.