Why the fountain of youth would unleash a flood of liabilities

7 February 2008

Let’s say you’re saving for retirement and you plan to live to the ripe old age of 85.  You save accordingly by socking away a certain amount every year and banking on the market to provide you with a tail wind to help you built just the right sized nest egg.  To your delight, your portfolio seems to be beating the S&P 500 year after year.  Way to go, fella! 

Then one day, magician David Copperfield announces that his quest for the fountain of youth has finally yielded some results.  He has scientific evidence that the stream running through his Bahamian plantation will allow anyone on Earth life to the age of 100. 

“Damn that Copperfield!” you exclaim.  Now you have to save a lot more for retirement than you had planned.  All of a sudden, beating the S&P 500 ain’t looking so hot anymore, eh?  You’re now on the hook to support yourself for an extra 15 years. 

Pension plans face this problem all the time.  In fact, a scan of FTSE 100 companies this week reveals that 10% of them had to raise their expectations of longevity this year alone - significantly increasing their future liabilities. 

Whether it’s increasing longevity, falling interest (discount) rates, or some other factor, pension liabilities fluctuate all the time.  Beating an arbitrary benchmark might be a good investment goal for pension fund, but it doesn’t put food on the tables of an army of 96 year old pensioners.  And if returns fail to impress, then insult is added to injury for pensions.  Falling returns and rising liabilities result in what Pensions & Investments recently called a “mini-perfect storm“.   

Enter Liability Driven Investing (LDI) - using a pension’s liabilities, not an investment objective as its bogey.  The problem is that every stream of pension liabilities is unique and depends on a number of factors including the timing of cash payments to pensioners.       

Last week, Northern Trust made the process of calculating that custom liability-driven bogey a bit easier for some of its clients.  The firm announced that its “Custom Liability Benchmarking” service will now be rolled out across its custody clients.  A web-based version is soon to follow.

Paul d’Ouville, global director of Investment Risk and Analytical Services at Northern Trust puts it this way:

“Pension plans exist for the purpose of providing benefits to participants, so the performance of assets relative to a plan’s liabilities is the key to measuring its ongoing viability. While indices are available to benchmark the average pension plan liability, Northern Trust believes there is no substitute for using the plan’s own unique liability structure to understand the inherent risk plan sponsors face in their own plan.”

Northern Trust has been offering this service to pension plan sponsors.  This white paper goes into more detail about why the firm thinks each pension plan should develop a customized investment bogey:

“When creating and analyzing a liability benchmark, it is important to know that each plan is unique in its characteristics. Plan demographics, plan type, participant age, number of participants and many other factors all come together to create a distinct liability cash flow profile. Certain providers in the marketplace offer liability indices that serve to benchmark the average pension plan liability. While these indices may give plan sponsors a sense of how the average pension plan is performing, there is no substitute for using the plan’s own unique liability structure to understand the inherent risk plan sponsors face in their own plan.”

To avoid actuarial hocus-pocus, the paper goes on to describe the characteristics of a good customized liability benchmark:

• Unambiguous
• Investable
• Measurable
• Appropriate
• Reflective of current investment options
• Specified in advance

Northern Trust’s timing may be pretty good.  P&I recently reported that clients of at least one global asset manager are ready to actually take the LDI plunge:

“Conversations with clients are focused now on how best to match assets and liabilities, rather than on debating the merits of LDI, said Mr. [Aaron] Meder [of UBS GAM].

“Mr. [Chris] Levell [of New England Pension Consultants] said a third of NEPC’s corporate clients have done some liability-driven investing, a figure that should push toward half by the end of 2008, despite the unfavorable moves in the equity and credit markets.”

David Copperfield…More power to him.  But if he’s ever successful, we’re all going to be seriously “under-funded” no matter how much we manage to beat the index.        

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4 Responses to “Why the fountain of youth would unleash a flood of liabilities”

1. Bill aka NO DooDahs! Says:
   February 8th, 2008 at 7:52 am

   I am SHOCKED! SHOCKED to find that actuaries engage in hocus-pocus!

2. John McLaughlin Says:
   February 8th, 2008 at 12:50 pm

   “Mr. [Chris] Levell [of New England Pension Consultants] said a third of NEPC’s corporate clients have done some liability-driven investing, a figure that should push toward half by the end of 2008, despite the unfavorable moves in the equity and credit markets.”

   Is it safe to say that “some liability-driven investing” is a misnomer. LDI is a strategic decision for a pension plan and must be managed on a portfolio level. Earmarking some funds as LDI funds is incongruent with the strategy.

3. Bond investor Says:
   February 9th, 2008 at 1:30 am

   Uh, Merrill and Lehman (and I think UBS, too) came out with Liability-Driven Investing indices last year, some with backdated returns going back decades. So NTRS is not doing anything particularly new.

   Prof. Miles Zvi has been on this track for years. I don’t understand why more pensions (corporate and government) haven’t done this. The biggest enemy of a pension is not having enough in long-dated bonds, regardless of interest rate levels. A matched-duration strategy means that even if rates rise, hurting the portfolio, the liabilities decline, because they are discounted at a higher rate. If anything, actuarial smoothing should be reduced so plans aren’t made in another galaxy when Treasury rates were at 6%…

4. Bond investor Says:
   February 21st, 2008 at 12:02 pm

   Sorry, in my Feb. 9 comment, make that Zvi Bodie, prof. of mgmt at Boston University, not Miles Zvi.

   The PBGC’s dramatic increase in equity allocation announced 2/18 provides an interesting additional aspect this this discussion. They had been 28% equities, no going to 45%. Their bond returns for 2006 were +3.47%, which suggests they did a HORRIBLE job managing their duration. Why weren’t they more in long AAA and/or long Tsy assets? Their liabilities are way the heck out in the future. Long govvies were up 8-11% in 2007.