Over the better part of the past decade, corporate defined benefit plans have adopted liability-driven investing, while their public plan counterparts have largely ignored this investment approach.
The lack of public defined benefit plan interest in LDI is not surprising, considering the regulatory environment and large aggregate unfunded liabilities.
We've all heard the plethora of dire media reports and such clarion calls as: “Public DB plans are on the brink of disaster!” “Pensioners should prepare for the worst!” “XYZ City is the next Detroit!”
To be sure, LDI isn't a magic bullet that will solve all of these concerns, but it is a philosophy and mindset that public plan executives should strongly consider for the long-term benefit of their plan participants as this strategy seeks to maximize the probability of meeting a plan's promised obligations.
So what does LDI mean for a public defined benefit plan, and why is it so important?
Unlike their corporate defined benefit plan counterparts, which measure their liabilities against a high-quality corporate bond curve, public plans discount their liabilities using an actuarial expected return. Today, we typically see expected returns of around 7½%. But this approach is going to change, and soon.
Pension regulations such as GASB 68 will soon take effect and change the way public plan liabilities are discounted. Funded liabilities will still be discounted using the current methodology (i.e., expected investment return). However, the difference under the Governmental Accounting Standards Board's Statement 68 is that unfunded liabilities will need to be discounted at a 20-year, AA-rated municipal bond rate, which today is approximately 3¼%.
So what would this actually mean? One dollar to be paid out in 10 years, discounted using an expected return of 7½%, is worth 49 cents today. In contrast, the same dollar discounted using the 20-year, AA municipal bond rate is worth 73 cents today.
If that dollar represents a future benefit payment, its present value under GASB 68 would be 50% higher! So as long as a public plan sponsor is managing a fully funded defined benefit plan, they have nothing to worry about. But how many public plans can make the claim of fully funded status?
To make matters even more challenging for public plans, a second important pension regulation, GASB Statement 67, compels public plans to reflect their net pension asset or liability on their financial statements.
So under GASB 68, liabilities will grow, and under GASB 67, the increased liability will be reflected on the financial statements. The noose is tightening, and this is only the first stage. It is a distinct possibility that, despite their public comments to the contrary, GASB members will move to full mark-to-market accounting within the next decade. Sound familiar?
On the corporate defined benefit side, the Pension Protection Act of 2006 and Financial Accounting Standard Board's Statement 158, adopted in 2008, introduced mark-to-market requirements and financial statement accountability, causing a massive shift in corporate plans' investment approach to LDI. We've seen this movie before.
And if that isn't enough, Moody's Investors Service Inc. recently changed its ratings methodology for municipalities. The new system essentially discounts public pension liabilities using high-quality corporate bond yields, recalculates the unfunded liability and amortizes it over a 20-year time period. Secondly, Moody's factors this assessment into its rating determinations, which now assign more importance to debt and unfunded pension liabilities in the updated methodology. This could spell trouble for the ratings of municipalities affected by this change.
Given the enhanced scrutiny, what are some practical first steps for public plan executives to both incorporate these new realities and meet their investment objectives? They include:
nestimate the plan's unfunded liabilities under GASB 68 methodologies and calculate the associated funded status impact;
nidentify the effect of potential plan reforms;
nestimate the plan's funded ratio volatility;
ndevelop a milestone plan that will get the pension plan to an appropriate funded status and funded ratio volatility; and, finally,
nfocus on risk management — not outsized returns!
LDI for public plans does not mean simply adopting traditional corporate defined benefit plan techniques. For example, should public plans immediately start investing in long-duration bonds? Probably not. Long-duration bonds might be a good match against corporate defined benefit liabilities, but corporate defined benefit plans are generally in far better economic shape and are able to change their investing mindset from total return to hedging.
However, we believe public plans should consider focusing on their near-term — that is, five- to seven-year — benefit payments and develop strategies that can immunize these obligations. We are seeing more and more plans finding comfort with immunization strategies that are both liability focused and seek to reduce exposure to interest rate risk.
Additionally, public plans should consider steps that go even further, like volatility-management strategies that avoid the potentially catastrophic effects of future market declines coupled with high correlations.
The reality is that those serving the public defined benefit plan space need to start focusing on the challenges that public defined benefit plans are facing holistically. The fundamental principles of LDI can help with this process. While every investment strategy should be highly customized to the plan sponsor's unique circumstances, the ominous economic situation of many public plans will require real innovation and forward thinking. It might indeed be time for LDI to go public.
David R. Wilson is managing director and head of the institutional solutions group, Nuveen Asset Management LLC, Chicago.