Plan sponsors are looking for ways to manage the following risks of defined benefit (DB) plans through both funding and investment policies: unexpected contributions, balance sheet volatility and increasing expenses. Liability-driven investing (LDI) has become an important part of this solution.
This brief, opinion article discusses a simple framework for explaining LDI in terms of three “levers.” These levers explain how a sponsor can help mitigate some of the plan’s risks, particularly interest rate risk using the hedge ratio. Sponsors desiring to increase their hedge ratios have these three key levers to pull:
- Funded status (contributions)
- LDI allocation
- Duration ratio
Ten years ago many plans were fully funded, but had not adopted an investment strategy to maintain that status. As plans work their way back to full funding, sponsors ought to consider which levers to pull to avoid repeating that history.