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Keeping Pension Funding Goals In Sight

Executing a liability-driven investment strategy using exchange-traded funds (ETFs)

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“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”

Benjamin Graham The Intelligent Investor, published in 1949.

Introduction

Liability-driven investing (LDI) has been a hot topic since the financial crisis of 2007–2008. Defined benefit (DB) pension plan sponsor and investment committee members recognize that a nominal investment expected return assumption is not as meaningful if the funding of a plan's liabilities are ignored. Despite this realization, few institutional portfolio managers have been able to combine the philosophy of liability goals based investing with the world of portfolio construction.

In this paper we explore how a liability-driven investing strategy used in pension plans is executed with the liquidity and low-cost nature of exchange-traded funds (ETFs). This presents a thoughtful and suitable LDI portfolio solution for a plan sponsor's objectives and priorities.

Defined Benefit (DB) Pension Plan Funded Ratios Are At Their Lowest Levels

DB pension plans are two-sided equations: assets and liabilities. Looking at only one side of the equation leads to misinterpreting pension fund dynamics. From 1999 to 2014, pension plan liabilities grew faster than stocks and bonds. This mismatch between assets and liabilities caused funded ratios to decline.

From 1999 to 2014, pension plan liabilities grew faster than stocks and bonds. This mismatch between assets and liabilities caused funded ratios to decline.

The funded ratio is assets divided by liabilities. This ratio is the percentage of assets to cover liability. Similarly, funding status is the dollar value of assets minus the liability. The funded ratio context can be illustrated by the annual report from S&P Dow Jones Indices, “S&P 500® Corporate Pensions and Other Post-Employment Benefits (OPEB): Heading Into the Sunset, a Half-Trillion Dollars Short,” on the state of S&P 500 company pension plans. The report spans over 15 years, ending with 2014. At the end of 2014, Standard & Poor’s 500 Index (S&P 500) company pension assets and liabilities were $1.7 trillion and $2.1 trillion respectively. This translates to a funded ratio of 81%, assets over liabilities.1 The reporting period saw two bull markets: one from 2003 to 2007, and the other from 2009 to 2014. Additionally, bond markets outperformed their historical long-term average. The S&P 500 and Barclays Capital U.S. Aggregate Bond Index (Barclays Aggregate) annual compound total returns were 4.2% and 5.7% respectively over the 15-year period. Although stocks typically outperform bonds over the long term, the Barclays Aggregate outperformed the S&P 500 during this time frame.

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