I saw an interesting article today. It said that 63% of pension execs (whatever execs represents in this case) are now using an LDI approach for pension funding. I saw an article on the same site that asked the question, "If LDI is so great, how come more funds aren't doing it?"
"I see", said the blind man who knows that LDI stands for Liability Driven Investing. In a nutshell, pension funds that employ this technique seek to mitigate funded status volatility by having a portfolio of assets that varies with moving interest rates in essentially the same way as the plan obligations move.
I first discussed LDI with a client in (I think this is the correct year) 1998. At the time, this company's US pension funds had an overall funded status well in excess of 125% on any measure. The technique that I discussed with them didn't have such a catchy name though. I think we called it duration modeling (doesn't sound too catchy, does it). The good news -- that company adopted what came to be known as an LDI strategy and never fell into the morass of underfunding suffered my most US pension plans. The bad news (for participants anyway) -- the company eventually froze their plans to save money.
Back in the very late 90s and early 2000s, I gave some speeches on the topic. I always heard the same response from the naysayers -- roughly, do you mean to tell me that you think interest rates are going to go down? These naysayers were generally the absolute return people. Despite all the logic, they didn't seem to understand that even if you thought that interest rates would go up (they didn't over the next 10 years or so), probabilistic or stochastic analysis showed that for most plans, you would be doing a far better job of risk management by matching assets with liabilities.
Let's consider. Suppose that in 75% of all cases, you thought interest rates would go up and in 25%, they would go down (let's assume that in very few would they stay the same and we will just split them evenly between the two groups). Unfortunately, especially under the new PPA funding regimes, the worst possible scenarios for plan sponsors -- the ones that might put them out of business -- all occurred where interest rates fell and the plan sponsor chose to not match assets to liabilities. In the more positive (return) cases, the group that matched didn't do as well as the group that bet that interest rates would go up, but even so, they should have been able to sleep better.
You see, the matching, or immunizing, group, was coming close to ensuring that their required contributions would not be enough to cause corporate financial ruin. Yes, they were taking away some of their upside potential, but isn't that what risk management and insurance are all about? When you insure your home, for example, you know that you probably won't have a large claim. So, you are spending money on insurance that you probably won't recover (essentially decreasing your upside potential). On the other hand, if you do have that large claim, you'll be glad that you had that insurance, and that's what LDI is all about.
Sadly, so many companies that knew this was the correct approach for them resisted and many of them either had to reduce benefits, or in some particularly severe cases, were essentially put out of business by their pension plans.
It's not worth all that. If you still have a US defined benefit plan, at least consider your risks and see what you might do to mitigate them.