Investors see the need for LDI benchmarks

NEW YORK — Pension executives are catching on to what the money management community has been telling them for years: There's another benchmark in town, and it has nothing to do with any stock or bond index.

Liability-driven investment benchmarks, used to measure the growth of pension assets against projected liabilities, have been around for some time.

Now however, the Pension Protection Act of 2006, which implemented stricter funding rules, and expected changes to the Financial Accounting Standard Board's Statement 87, which is supposed to eliminate actuarial smoothing, have prompted more pension plans to at least consider using a liability-based benchmark.

Among funds using the benchmarks are the $10 billion World Bank pension fund, Washington, and the $6.9 billion pension plan of International Paper Inc., Stamford, Conn. The $4.1 billion pension plan of First Energy Corp., Akron, is looking at them.

In setting a benchmark to liabilities, plan executives can generally choose either a Treasury strip benchmark, which uses zero-coupon bonds to measure the general growth of liabilities, or an interest-rate swap benchmark, which uses the coupon rates of long-term, investment-grade bonds to measure the general growth rate of corporate pension liabilities.

Ron Ryan, president of Ryan ALM Inc., New York, was among the first to introduce liability-based benchmarks when he developed the concept of using a Treasury strip benchmark to measure liabilities in the mid-1980s. Nobel Laureate William Sharpe wrote about the liability-based benchmark concept in a January 1990 paper in the Journal of Portfolio Management.

Now, however, these benchmarks are being adopted either in place of — or as a supplement to — traditional performance-based benchmarks to measure total fund performance, according to money management industry executives.

Arjan B. Berkelaar, principal investment officer of quantitative strategies and risk and analytics treasury for the World Bank, said the organization's pension plan just switched to a swap-based benchmark. "It just makes sense," said Mr. Berkelaar. "Our job is to see if we can fulfill our obligations. That's why we need to do this."

International Paper officials plan to implement an interest-rate swap strategy for about half its pension assets over the next two years, in order to align assets with liabilities, said Robert Hunkeler, investment officer. He added the plan already uses a swap-based liability benchmark to measure how much in returns it is adding in excess of its liabilities.

"Right now, using a liability-based benchmark is something that we're just in the very early stages of looking at," said Don Perrine, director of investments for First Energy's pension plan. "There will always be a place for performance-based benchmarks, but with the current pension reform and accounting changes coming, we felt it is something we should take a look at."

The Pension Protection Act of 2006 is prompting some pension executives to consider using liability-based benchmarks, said David Chittim, a senior vice president at Mellon Asset Management, Pittsburgh. "The PPA has taken away a lot of the funding smoothing that pension plans typically used," he said. "Upcoming accounting changes look like they will take away a lot of that as well, so the performance of the assets vs. the liabilities in a pension plan becomes all the more important."

Money managers have responded to pension clients' desire to use some form of a liability-based benchmark. Firms such as UBS Global Asset Management, Chicago; Mellon Asset Management; and SEI Investments, Oaks, Pa., have introduced such benchmarks to their clients within the past year.

"We've seen a tremendous amount of interest in using liability-based benchmarks in the past few months," said Mellon's Mr. Chittim, the creator of the firm's new line of liability-based benchmarks, which track the liabilities of the average young pension plan with an 18-year liability stream and a mature pension plan with a liability stream of about a decade.

"I think that performance-based benchmarks are still used to measure manager performance, but one based on liabilities incorporates asset allocation and manager performance and is used to measure the performance of a plan as a whole," he said. "We've seen in various studies that most of the returns of a pension plan come from the asset allocation. The performance of individual managers is a relatively minor contributing factor."

Howard Pohl, a senior consultant at Becker, Burke & Associates Inc., Chicago, said some of his corporate pension plan clients are beginning to use liability-based benchmarks.

"To a small amount (using liability-based benchmarks) certainly is something that more and more funds are focusing on," he said. "Certainly, I think the Pension Protection Act and the expected changes to FAS 87 are the driving forces. While these are factors that are certainly on the minds of the corporate pension executives, it is likely that that it will also be on the minds of public funds in the future as the Government Accounting Standards Board (the governing body that regulates accounting rules for public pension plans) will change as well."