OVER THE PAST decade, defined benefit (DB) plan sponsors have had a wild ride on the funding roller-coaster, with many plans falling from well-funded positions to under-funded positions in just a few short years.  Numerous high-profile plan insolvencies have served as a wake-up call to legislators, resulting in the passage of the Pension Protection Act of 2006 (PPA), as well as the adoption of funding and accounting reforms.  The stricter funding requirements and greater financial transparency have placed increased attention on the need to control pension plan surplus volatility.

Diversified Investment Advisors, Inc.’s recently published white-paper, “Liability Driven Investing – The Efficient Frontier,” examines the basic tenets of an LDI strategy and how it can be used to manage the financial gap between a DB plan’s assets and liabilities.  LDI is an investment strategy that considers liability characteristics when making asset allocation decisions.  It also focuses on measuring total surplus risk attributable to changing interest rates and duration of bond allocations and liabilities, as well as exposure to equities.  The approach consists of finding an appropriate combination of investments that seeks to minimize long-term interest rate risk and potentially enhance return.  The risk-reducing or “Beta” portfolio may include a mix of fixed income, including traditional instruments, long duration securities, and inflation-protected securities.  The return-enhancing “Alpha” portfolio may include traditional equity investments, as well as other potential return-enhancing assets such as hedge funds, real estate, commodities, and high-yield bonds.  How plan sponsors allocate between Alpha and Beta portfolios depends on many factors, such as the plan’s active versus frozen status, funding level, demographics, and the need to minimize contributions and/or financial statement volatility.

As an advisor, you can add value to your relationships by helping clients gain a better understanding of how the principles of LDI work and how it may be used in a DB plan strategy.  The recent legislative and accounting changes have created new challenges for pension plan sponsors and LDI may be an alternative to manage surplus volatility as part of your clients’ DB investment strategy.

To learn more about Diversified, call 800-770-6797 or visit their Web site at www.divinvest.com.

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