Plan sponsors need to revisit liability matching

Pension plan sponsors need to think about liabilities as a benchmark and how a risk/reward strategy can reduce them in the future, according to State Street Global Advisors.

Speaking to reporters, Sean Flannery, chief investment officer with State Street in Boston, said although liability driven investments seemed quaint in the 1990s, when equities were booming, the notion has returned and needs to be considered by plan sponsors.

“The index tail was wagging the investment dog,” he said, referring to the notion that almost everyone was used to equity index investing.

The problem is that equity indices were never intended to be used as a target, but simply as a benchmark to compare managers’ investment performance. An equity index has little interest in tracking a pension fund’s future liabilities, so why should a manager track the index?

Flannery says sponsors should look at lowering liability and volatility in a risk-free way, thereby freeing up the so-called “risk budget” to be used elsewhere in the portfolio.

“A pension fund should only take risk that it can afford to take,” he said. Meaning, by adding liabilities to the investment equation, a plan sponsor can add return to its investments without adding risk.

The real risk, he said, is not having the money to pay retirees. A strategy proposed by State Street is the 130/30 strategy. In essence, this strategy takes a 130% “long” position on the overall market, while shorting 30%. The net effect is to be long 100% of the market, while allowing the manager to use their skill in identifying the likely laggards, thereby reducing risk

“Conventional thinking will not solve this problem,” said Carl Bang, president and managing director of State Street Global Advisors, Canada.

Even if regulators do not require them to aggressively close the gap, plan sponsors can be sure that equity analysts will recognize the future liability they face.

While Flannery is reluctant to label this a hedging strategy, he says it is conceptually an index fund with a hedge fund layered on top. Flannery said that State Street would introduce such a strategy into the Canadian market in the second quarter of 2006.

To take advantage of such a strategy, however, most plan sponsors will have to change their plan mandate to allow shorting. But with many plans facing a funding gap, they may have little choice.

Filed by Joel Kranc, Benefits Canada

(03/23/06)