Liability Driven Investing Position Paper, Part 2 (of 2)

Transcription

1 Liability Driven Investing Position Paper, Part 2 (of 2) May 2012 PREPARED BY Gregory J. Leonberger, FSA, EA, MAAA Director of Research Abstract Over the last five years, Liability Driven Investing ( LDI ) has grown in popularity as an investment strategy for pension plan sponsors. Our two part position paper series on LDI takes a close look at LDI strategies, with an emphasis on the if and how : deciding IF an LDI strategy is appropriate for a given pension plan, and if so, HOW it should be implemented. In Part I, we examined the motivations for LDI, how an LDI strategy works, and suitability for clients. Part II is intended for plan sponsors who have decided to implement an LDI strategy, and covers the practical issues surrounding implementation and maintenance, along with risks. Manager selection and the current environment for LDI are also covered. Ultimately, this paper is intended to serve as a guide for plan sponsors designing and installing LDI strategies for their plans. PREPARED BY MARQUETTE ASSOCIATES 180 North LaSalle St, Ste 3500, Chicago, Illinois PHONE WEB marquetteassociates.com

2 Implementation Once a decision is made to proceed with an LDI mandate, plan sponsors in conjunction with their investment consultant and actuary must make several decisions regarding implementation. The first and most basic is to establish a firm understanding of the plan s future cash flows and inherent duration. Developing a precise measure of a plan s duration (and less importantly, convexity) is mandatory for any effective LDI strategy. With the duration value in hand, it is then necessary to determine an initial hedge ratio. The hedge ratio is the percentage of liability that will be insulated from interest rate shocks. In other words, it is the percentage of the liability that is hedged from interest rate movements. It is rare for new LDI mandates to immediately implement a 100% hedge ratio; a more common first step is 30%. For clients that have already started down the LDI path, the conversation is not about an initial hedge ratio, but increasing the hedge ratio; a healthy target hedge ratio is in the 50 60% range. 1 Similar to the progression covered in Part I (Exhibits 3 7), the plan sponsor may initially move to a 40% hedge ratio, and further progress towards a 60% hedge. In some cases, the hedge may approach 90% if such a move is prudent for a pension fund. The main take away is that for successful implementation, a hedge ratio needs to be established before the formal adoption of an LDI strategy. In addition, it is imperative that plan sponsors understand that establishing a hedge ratio has material ramifications on a plan s asset allocation, as most LDI mandates will feature a move away from risk assets into more bonds. 2 Armed with a target hedge ratio, the next step is to decide which financial instruments will be utilized to increase the portfolio s duration to achieve the stated liability hedge ratio. Usually, the asset manager chosen to assist with the LDI mandate (see section on manager selection later in this paper) will be heavily involved with this decision, but it is beneficial for all parties to be in agreement. LDI solutions typically feature a high degree of customization, and the implementation will not be the same across different funds or asset managers. Generally speaking, bonds or derivatives can be utilized to increase the portfolio duration. In the case of actual bonds (generally preferred whenever possible versus derivatives) portfolio duration can be increased by lengthening the duration of the current bond portfolio 3 or a greater allocation to bonds in the portfolio. 4 Of course, there are trade-offs with this decision, most notably that increasing the allocation of bonds will decrease the expected rate of return on the entire portfolio, which will increase pension expense (see appendix). The following covers the most frequent tools used to implement LDI mandates: Increase allocation to bonds Lengthen duration of current bond portfolio Increase credit exposure to introduce more spread sensitivity 5 Add STRIPS to further extend duration (usually replacing Long Government bonds) 1 For ongoing plans, it is not practical to implement a hedge ratio much higher than this, as some risk seeking assets must be preserved in the portfolio so that the growth of the assets can keep pace with the growing liabilities as new and current participants continue to accrue benefits. 2 Some plan sponsors may actually reverse the decision making order, first deciding how much of their portfolio to dedicate towards liability hedging, and then developing a specific liability hedge ratio based on the overall asset allocation. 3 Similar to the move from Exhibit 3 to Exhibit 4 in Part I when we simply changed the index from Government/Credit to Long Government/Credit which easily adds duration. 4 Similar to Exhibits 4 and 5 in Part I when we moved the allocation to Long Government/Credit from 40% to 50%. 5 As mentioned earlier, pension liabilities are based on corporate bonds which have both interest rate risk and credit spread risk; adding additional credit exposure can help to hedge against spread risk, as government bonds essentially have zero spread duration. Liability Driven Investment Position Paper Part 2 May

3 Treasury futures to extend duration or create more exposure to bonds Swaps and swaptions 6 Naturally, these tools are not mutually exclusive and over time as clients increase their hedge ratio they will utilize multiple instruments from this list, either simultaneously or graduate from the more simplistic to the more sophisticated as dictated by hedge ratio and market conditions. Again, the degree of customization sought by the plan sponsor will govern which of these instruments are utilized. A plan making its first foray into LDI may just move to a longer duration bond portfolio. Others pursuing a greater hedge ratio may implement more exotic strategies featuring swaptions, equity collars, and other derivatives. The use of derivatives instead of physical bonds will increase not only as the level of customization increases (since it is easier to customize across the liability curve using derivatives instead of physical bonds), but also as the duration of the liability increases. For plans with low liability durations typically very mature plans that have been closed for a considerable amount of time - it is easier to customize a corresponding bond portfolio because sufficient supply of shorter-dated bonds exists in the market. On the other hand, derivatives offer the benefit of extending duration with less capital due to leverage. In addition, as covered under the Risks section later in this paper, there is a limited supply of long duration corporate bonds. Ultimately, the balance between physical bonds and derivatives will differ based on the degree of customization pursued, but the cost, complexity, and counterparty risk inherent in any derivatives-based strategy usually pushes the needle toward physical bonds when given an objective choice between the two. Another key implementation concept is the movement from a lower to a higher hedge ratio. It is not common for plans to make large singular moves with their hedge ratios; a glide path implementation is more typical, done in 5 10% increments. The incremental approach is recommended and utilized because of two main reasons: Improvements in funding ratio are usually gradual, so it makes sense to increase the hedge ratio as funding ratio improves; and It is easier to achieve buy-in from key decision makers if the process is structured and gradual; a radical shift in asset allocation coupled with a significantly lower expected return on assets can be challenging for senior management to readily accept. Increases in hedge ratios are usually dictated by improvements in funding ratios 7, interest rates, time, or a combination of these factors. As mentioned above, funding ratios and interest rates are closely linked, so in essence the funding ratio and interest rate trigger tend to be highly correlated. In terms of which interest rate to follow, any longer-term interest rate is acceptable, with the total yield of the Long Government/Credit Index perhaps most appropriate as it is readily available and of long duration, not unlike pension liabilities. Generally speaking, we prefer to construct glide paths based on funding ratio, since that is a true snapshot of a plan s funded status, whereas a glide path based on interest rates may not capture all of the movements in a plan s funded status. 8 6 As of publishing date, a more sophisticated strategy is for pension funds to purchase a receiver swaption to protect against falling rates and to sell a payer swaption at a higher rate to pay for the receiver swaption. 7 Funding ratios are driven by contribution amounts, market performance, and market interest rates - since liabilities are a product of those market rates. 8 For example, interest rates may rise 50 basis points but if spreads move in an opposite direction, the funded status may not change, or may even worsen; in addition, interest rate movements may not correlate to favorable asset movement, therefore confusing the ultimate impact to a plan s funded ratio. Liability Driven Investment Position Paper Part 2 May

4 A glide path based on funding ratios may look something like this 9 : Exhibit 1: Glide Path Example Funded Status Allocation to Fixed Income Fixed Income Portfolio Liability Hedge Ratios Interest Rate Risk Spread Risk <85% 40% Long Govt/Credit 40% 23% 85% - 90% 45% Long Govt/Credit 45% 26% 90% - 95% 55% STRIPS/Long Credit 67% 32% 95% - 100% 65% STRIPS/Long Credit 79% 38% >100% 80% STRIPS/Long Credit 98% 47% Actual glide paths will vary considerably among plan sponsors, each unique to the plan s dynamics and funding status. Although glide paths will differ for plans, it is recommended that for every mandate, the glide path be written into investment policy guidelines so that implementation can move forward quickly and seamlessly to take advantage of market and plan developments (i.e., funded ratio crosses a new threshold). Without the glide path written into investment policy guidelines, it is too easy to delay the decision or for the move to be held up: by the time a final decision is made, the conditions may have disappeared, therefore reducing the merits of the further move along the path. It is much more efficient and practical to have the glide path written in the investment policy guidelines to provide for pre-approved increases in the hedge ratio. An additional consideration for plan sponsors considering a large LDI mandate in pursuit of a high hedge ratio is to ensure that the methodology used in the actuarial valuation matches those embedded in an LDI strategy. For example, if liabilities are measured by rates as of a single date without any averaging (as governed by ASC 715 regulations), then the assets used in the valuation should be as of a singular date as well (as opposed to using smoothed assets). 10 Similarly, a full yield curve approach for PPA funding valuations is more in line with LDI than the use of segment rates. As mentioned in Part I, plan sponsors also need to prioritize which measure of funded status they are most concerned about PPA funding rules or ASC 715 accounting rules. The plan sponsor, actuary, and investment consultant should work in conjunction to develop consistent methodologies for the measurement of assets, liabilities, and their inter-dynamics to create the most beneficial LDI strategy for the plan. Monitoring / Maintenance At a minimum, the changes in discount rates, assets, and liabilities should be reported at quarter end to illustrate how changes in assets and liabilities affected the plan s funded status. A simple summary may look like this: Exhibit 2: Basic Summary Quarter-End Prior Quarter-End Change Market Value of Assets ($M) $ $ $(40.34) Market Liability ($M) $ $1, $(73.00) Market Discount Rate 5.50% 5.00% 0.50% Market Funded Ratio 87.3% 85.0% 2.3% 9 This example is based on our initial sample pension liability of $1.0B and duration of 12. The LDI portfolio moves from the Long Government/Credit index to the STRIPS/Long Credit blend as the funding ratio increases, similar to Exhibits 3 7 in Part I. 10 Most plan sponsors contemplating a larger commitment to LDI probably have elected to use asset smoothing for their funding valuations, and the switch to market measure can only be done once. In this case, the move to a market measure should be considered as an option that should be implemented when valuable to the plan and its associated metrics; the decision to switch back to market should be analyzed on each valuation date. Liability Driven Investing Position Paper Part 2 May

5 Although the previous table is helpful for a high level summary, it does not offer any kind of attribution analysis of how the liabilities, assets, and funded status changed, especially in relation to any overarching LDI mandate. The following reconciliation of funded status (based on the same table above and Exhibit 6 from Part I) is considerably more informative: Exhibit 3: Reconciliation of Funded Status QUARTERLY FUNDED STATUS RECONCILIATION Market Basis Liability ($M) Total Assets ($M) Liability Value (Beginning) $1, Market Value (Beginning) $ Funded Status Change ($M) Actuarial Changes $ - $ - Service Cost $7.50 Sponsor Contribution $7.50 $ - Benefit Payments $ (25.00) Benefit Payments $(25.00) $ - Accrual $4.50 Accrual $3.83 $ (0.68) Risk Asset Excess Return $19.34 $19.34 Price Performance General Interest Rates (90) Price Performance Hedged (61%) $(54.77) Interest Rate Hedge $(54.77) $ - Unhedged (39%) $(35.23) $35.23 Credit Spreads 30 Hedged (29%) $8.77 Credit Spread Hedge $8.77 $ - Unhedged (71%) $21.23 $(21.23) Liability Value (Ending) $ Market Value (Ending) $ $32.66 Assumptions ($M where appropriate) Annual Service Cost (i.e. cost of benefit accrual) 30 Annual Benefit Payments 100 Accrual based on short-term credit index FI allocation (21% 15+ STRIPS, 29% Long Credit 0.45% 50.00% Risk Asset allocation 50.00% Liability Duration 12 Interest Rate Change 0.75% Credit Spread Change -0.25% Sponsor contribution assumed to cover Service Cost Quarterly Risk Asset Return 5.00% The table above allows the plan sponsor to monitor each item of the funded status equation. On the liability side, benefit accruals (service cost), actuarial changes (such as an assumption change), benefit payments, and interest on the liability over the quarter are summarized. In addition, the impact of a rate change and spread change are calculated in total as well as in relation to the proportion of the liability that is hedged for rates and spreads. Liability Driven Investing Position Paper Part 2 May

6 On the asset side, similar calculations account for contributions made to the plan, benefit payments out of the trust, short term interest on the portfolio, as well as the return from the risk assets in the portfolio. Critically, we can also see how the LDI portion of the portfolio performs as rates and spreads move (in this case, in divergent directions). Such a summary is extremely insightful to plan sponsors so they can better understand the hedges in their portfolios, and how they hold up as rates and spreads move. As with any investment strategy, transparency is vital to the success of the program and a summary like the one above provides greater clarity into the strategy. However, detailed reporting on a plan s LDI mandate is only one element of a successful monitoring program. Because there are so many moving pieces of the funding status equation, additional factors need to be assessed on a regular basis. In fact, all factors analyzed before making a commitment to an LDI mandate should be consistently reassessed, as a change in any of those could beget an adjustment to the underlying hedge ratio. At a minimum, the funded status should be calculated at quarter end, and any upcoming plan changes should be analyzed in relation to the current LDI mandate. In addition, capital market performance of both the LDI portfolio and risk assets should be considered. Large contributions either recently made or upcoming can have an impact on adjustments to an LDI mandate (typically, a large contribution will force clients further down their glide paths since funded status will improve). Last but not least, managers hired for the LDI mandate who are not successfully delivering on performance expectations should be reviewed and placed on alert as necessary. Although LDI shifts the focus away from pursuing a singular rate of return for a portfolio, it is still necessary to develop a benchmark by which to evaluate managers and overall strategy. This topic is material enough for its own paper, so we will be considerably more brief and instead stress that the benchmark utilized to assess the performance of LDI portfolios must accurately embody the plan s exposure not only to the mix of risk assets and bonds, but the split between credit and government bonds. For plan sponsors with large allocations to risk assets, the bond benchmark and portfolio should be more heavily tilted towards government bonds since corporate bonds essentially double down on the exposure to corporate defaults. 11 The opposite is also true: if a plan is significantly along its glidepath and the equity exposure is low, a larger exposure to credit is recommended. These trends should be reflected in both the portfolio construction as well as the chosen benchmark. Risks Although LDI mandates are designed to reduce the risk of funding status volatility, there are still risks associated with moving from a traditional portfolio to one designed to mimic a plan s liabilities. To begin with, pension plan liabilities are subject to interest rate and credit spread risk; a move in either of these metrics can impact a plan s liability. While it is relatively straightforward to establish the desired interest rate hedge, it is more difficult to hedge the credit spread risk. Further compounding this problem is that as the credit spread hedge ratio is increased, a pension plan is likely taking on more credit risk with its portfolio. Thus, a risk asymmetry is introduced: although the pension plan s liability is developed using corporate bond yields, the liability is essentially risk free, meaning that no matter what happens in the credit markets, the liabilities do not default the plan sponsor is obligated to make its promised payments to participants. On the other hand, defaults do happen, which can reduce the value of the corporate bonds held in the plan sponsor s investment portfolio If a corporation defaults on their bonds, its stock is likely falling in value. 12 In reality, defaults effectively double down on funded status, because when a defaulted bond drops out of the index, the overall yield of the index decreases, therefore increasing the liability of the pension fund and decreasing funded status. Liability Driven Investing Position Paper Part 2 May

7 Therefore, most plan sponsors hold a blend of government and corporate bonds in their LDI portfolios, which is beneficial from a credit quality perspective, but comes at the expense of a lower credit spread ratio. 13 Closely tied to the concept of balancing interest rate risk with credit spread risk is accounting for the mismatch of bond payments and future benefit payments. From a big picture perspective it is relatively straightforward to establish the desired hedge ratios by creating bond portfolios with the correct amount of interest rate and credit spread durations to match those of the overall pension plan liability. Yet, it is nearly impossible to precisely align the benefit payments from an LDI portfolio and a plan s liability profile. The future cash flows of pension plans are considerably more long-lived than any bond portfolio, thus for any non-parallel shifts in the yield curve the liabilities and assets will not move in perfect harmony. Plan sponsors who implement an LDI strategy must understand that even if the hedge ratios are accurate, the mismatch of underlying cash flows between assets and liabilities makes it impossible to eliminate all funding status volatility. Corporate plan sponsors must also consider the ramifications of an LDI mandate on the parent entity. Publicly traded companies are required to report an annual profit and loss figure on their financial reports (known as ASC 715 pension expense), and one critical component of this figure (see appendix for examples) is the expected rate of return on assets. For most traditional portfolios, this rate of return is around 8%. However, as LDI mandates feature a much larger allocation to bonds the expected rate of return is likely to decrease, in some cases rather dramatically. Subsequently all other expense components being equal - pension expense will rise, reducing corporate profits. Thus, the impact of moving toward an LDI mandate needs to be analyzed in the context of the pension fund, lower funding status volatility, and the corporation s earnings. Another risk item concerns the concentration risk and supply of high-quality long-dated corporate bonds. To begin with, the Long AAA-AA index has only 23 distinct issuers, and 63% of the market value is from only five issuers. 14 If one of these issuers experiences a downgrade or default, the whole index would be negatively impacted in a material way. More importantly, the limited supply of long corporate bonds could create legitimate supply shortages for those looking to install LDI mandates, should increased demand suddenly arise in the market. A 10% shift of DB assets into long corporate bonds would represent $250 billion of demand, which is more than 30% of the existing universe and represents three to four times the net supply. 15 Given the limited supply, plan sponsors may be forced to turn to derivatives instead of physical bonds to execute on LDI strategies. While derivatives are currently used to pursue LDI mandates, they do introduce additional risk and cost. As mentioned earlier, whenever possible, the use of physical bonds to implement LDI strategies is preferred. Given a potential supply shortage in the future, there could be some reward for being an early adopter of an LDI mandate. Awareness of and critically, controlling for these risks will help to ensure a successful LDI program. While it may be impossible to completely absolve plans of these risks, acknowledgement of and developing strategies to mitigate them will help create a less volatile funding status and more predictable results as discount rates move unpredictably over both the short- and long-term. 13 Though as noted earlier in the paper the majority of discount rate changes come from changes in interest rates as opposed to spread. 14 ING Investment Management 15 Income Research, December 2011 Liability Driven Investing Position Paper Part 2 May

8 Manager Selection An initial LDI mandate will often target an interest rate hedge ratio of approximately 30% (with a lower spread hedge ratio), and frequently, this first LDI step can be achieved with index funds. However, as a plan increases its hedge ratios, active management becomes necessary to truly develop and implement an LDI strategy which effectively hedges the unique liabilities of a pension plan and its underlying characteristics (plan design, demographics, actuarial assumptions, etc.). As such, proper time and resources must be dedicated to select the appropriate manager to execute on the LDI strategy. The most optimal LDI managers will demonstrate the following characteristics: LDI is a core competency: the manager has a proven track record of designing and implementing customized LDI solutions for pension clients. It should be noted that managers simply offering a long bond strategy is not evidence of successfully implementing LDI solutions, as LDI solutions require customization and careful attention to the liabilities inherent in a pension plan. The manager must be able to not only implement basic LDI solutions using physical bonds, but also develop customized solutions featuring derivatives. It is preferable that the manager employ credentialed actuaries so as to best synchronize comprehension and strategy with the plan s actuary and investment committee. Proven track record of credit selection and management: because pension liabilities are based on corporate bonds, LDI managers should demonstrate successful credit selection and management when it comes to investing in corporate bonds, since these bonds must support the interest rate and credit spread hedge initiatives of an LDI mandate. The ability to add alpha via credit selection while avoiding bonds that suffer downgrades - can enhance the overall effectiveness of a client s LDI mandate. From a practical sense, we find it is easiest to implement and monitor an LDI strategy if one manager handles the entire mandate. However, some clients choose to retain multiple managers to implement an LDI strategy. When this method is chosen, it is necessary to choose a completion manager who serves as the coordinator of the mandate, ensuring that each manager carries out his specific responsibilities; it is also the role of the completion manager to complete the LDI mandate by filling in any holes left by the other managers. For example, if an interest rate hedge ratio of 65% and spread hedge ratio of 40% is selected and the other managers have implemented their hedges to achieve a 55% interest rate hedge and 30% spread hedge, the completion manager builds a portfolio to round out the hedges to 65%/40%. Regardless if a manager is selected to carry out the entire LDI mandate or as the completion manager, thorough due diligence on each candidate is paramount. LDI strategies have only really existed in the U.S. for about five years (though LDI in Europe dates back to the early 2000 s), so it is necessary to confirm that managers have demonstrated the ability to assemble high quality LDI solutions featuring the appropriate actuarial analysis, credit research, and customization. Current Environment for LDI As of April 2012, interest rates and corporate bond yields are near all-time lows, making fixed income investments expensive, with little room for appreciation. Many market pundits believe that interest rates are more likely to rise than fall over the next few years, if for no other reason than rates can not drop much further. Given the overall mismatch of durations between assets and liabilities for most pension plans, if one has Liability Driven Investing Position Paper Part 2 May

9 conviction that rates will rise instead of fall, it could indeed pay off to maintain the duration mismatch between assets and liabilities, for the simple reason that if rates rise (assuming capital markets are flat), liabilities will fall more than assets, therefore instantly improving a plan s funded status without any contributions. 16 This rationale has been one of the reasons that some plan sponsors have delayed further implementation of LDI mandates. While interest rates and spread movements have proven notoriously difficult to predict, for those with extreme confidence in upward future rate movements, it is understandable why they may choose to wait. On the other hand, many plan sponsors have recently made large contributions to their plans, therefore fully funding their plans, or at the least, significantly increasing the funded ratio. Understandably, these plan sponsors do not want to risk large losses on the dollars they have recently added, so despite the low interest rate environment, they are moving further along their LDI implementation paths, as the large contributions have improved the funding ratios. In addition to the recent large contributions, plan sponsors continue to close and freeze pension plans, instead pushing participants into defined contribution ( DC ) plans. The move toward plan freezes coupled with large contributions are the driving forces behind the larger LDI mandates. Funding ratios are improving and sponsors do not want to see further decreases in funded status. Pension funds are also at the mercy of monetary policy decisions which can drive interest rates lower or higher. For example, the operation twist announcement by the Fed effectively lowered rates on the long end of the curve; since pension plan liabilities are long-dated, they are impacted more by changes on the long end of the curve. Operation twist essentially lowered the discount rates used to value pension plans, so for funds that were not hedged appropriately, the asymmetry of interest rates movements harmed many of the plans funding ratios, as the longer duration liabilities grew by more than the accompanying assets. Lastly, the volatility of the capital markets has made it even more difficult for plan sponsors to control their funding status with any sort of predictability. While 2-3% swings in the equity markets were considered exceptional prior to the financial crisis of 2008, such movements are far more common these days. With the required market measurements of ASC 715 and PPA, asset values are even more exposed to violent swings in the markets, which can notably impact funding status. This volatility, coupled with large drops in interest rates, has been the prime catalyst in pushing plan sponsors away from DB plans and towards DC plans, as DC plans shift the investment risk to participants. The plan sponsors risk is essentially eliminated as they are only on the hook for matching contributions to participant contributions, instead of large contributions at the worst possible time. 17 Recommendation Marquette believes that LDI makes sense for pension plans that adhere to PPA and ASC 715 regulations, that is, report liabilities and assets at market values, which are exposed to rapid and unpredictable shifts. While each LDI solution will be customized to a plan s specific circumstances, the following guidance is offered: Establish an initial interest rate hedge ratio of 30%. Develop an implementation glide path that improves the hedge ratios to at least 60% (interest rate) and 25% (credit spread) as funded status improves. The implementation glide path should be written into the investment policy guidelines to ensure a 16 For example, assume the liability duration is 12, the asset duration is 4, funded status is 80%. If rates rise 100 bps, the funded status improves to 87% because the liabilities decrease more than the assets. 17 That is, when rates have fallen, risk assets have fallen, and in most cases, the economy is slowing so their businesses are facing lower revenues and in some cases, contingency measures are enacted. Liability Driven Investing Position Paper Part 2 May

10 seamless transition to a larger LDI mandate. Whenever possible, physical bonds should be used instead of derivatives to implement an LDI strategy. Identify the appropriate benchmark to track performance; the benchmark should accurately reflect the underlying exposure to credit and government bonds as well as risk assets. Regularly monitor the effectiveness of the overall strategy and managers by reconciling asset, liability, and funded status at least quarterly, if not more frequently. Select the most qualified asset manager to implement the LDI mandate. Managers should be assessed on their experience, resources, and ability to customize solutions. Plan sponsors must understand the ramifications (good and bad) of moving toward a larger LDI mandate, perhaps none more important than the potential impact of LDI on corporate earnings. As always, clients are encouraged to assess LDI in light of their own circumstances, including demographics, risk tolerance, return goals, plan design, and corporate earnings. Additionally, consideration should be given to the size of the pension plan relative to the parent company s entire organization. In working to develop an LDI strategy, it is of paramount importance that the investment consultant, actuary, and plan sponsor work in harmony to develop the most optimal solution for each plan. Liability Driven Investing Position Paper Part 2 May

11 APPENDIX A Expected Return and Pension Expense As discussed throughout the paper, the movement toward a LDI mandate can have a notable effect on pension expense, because one of the components of this calculation is the expected return on assets. For the classic 60/40 portfolio referenced throughout the paper, this value is usually somewhere between 7-8%. For a portfolio with a large LDI mandate, this number will be lower. In the examples below, we compare two expense calculations using these two portfolios, with expected return on assets of 8% and 6%, respectively. The only difference in the two calculations is the return on asset value: 18 Exhibit 13: Pension Expense Examples Expected rate of return on assets = 8.00% 6.00% ASC 715 Funded Status PBO $1, $1, FVA $ $ Funded Status $ (150.00) $ (150.00) Net (G)/L $ - $ - Prior Service Cost $ - $ - Accum OCI $ - $ - Net Asset $ (150.00) $ (150.00) ASC 715 Expense Service Cost $31.65 $31.65 Interest Cost $52.25 $52.25 Expected Return On Assets $ (65.20) $ (48.90) Amort of (G)/L $ - $ - Amort of PSC $ - $ - NPPC $18.70 $35.00 As seen from the example above, a reduction in expected return of 200 bps nearly doubles the expense. It is easy to understand why corporate leaders are thinking twice before plowing ahead with large LDI mandates. APPENDIX B Disclosures Index data used in sample calculations and analysis is from Bloomberg, as of November 29, All examples are meant to be conceptual and are in no way a guarantee of performance. The materials presented in this paper do not constitute an actuarial opinion on behalf of the author or Marquette Associates, Inc. 18 For simplicity, we assume 0 for Unamortized Gain/Loss and Prior Service Cost. Liability Driven Investing Position Paper Part 2 May

12 PREPARED BY MARQUETTE ASSOCIATES 180 North LaSalle St, Ste 3500, Chicago, Illinois PHONE WEB marquetteassociates.com The sources of information used in this report are believed to be reliable. Marquette has not independently verified all of the information and its accuracy cannot be guaranteed. Opinions, estimates, projections and comments on financial market trends constitute our judgment and are subject to change without notice. References to specific securities are for illustrative purposes only and do not constitute recommendations. Past performance does not guarantee future results. About Marquette Associates Marquette Associates is an independent investment consulting firm that guides institutional investment programs with a focused three-point approach and careful research. For over 25 years Marquette has served this mission in close collaboration with clients enabling institutions to be more effective investment stewards. Marquette is a completely independent and 100% employee-owned consultancy founded with the sole purpose of advising institutions. For more information, please visit Liability Driven Investing Position Paper Part 2 May