aiCIO: One question in our survey this year was regarding pension plan endgames. Are buy-outs going to win the day, or is LDI going to continue its dominance through the end of the pension?
Wilson: I think it might end in a tie. There are many benefits to pursuing an LDI approach. The benefits include the ability to reduce the ultimate cost of the plan through investment returns and upward interest rate movements.
But many plan sponsors don’t want to spend an inordinate amount of time on their pension plan, especially as a wind-down business. LDI arguably is more efficient from a cost perspective, although I know many annuity providers who would have an argument with that. A lump-sum offering is an interesting option. You discount the pension obligations using a very similar corporate curve to the discounting curves that are used to measure either your balance sheet exposure or to quantify funding needs. So, lump sum offerings are a very efficient way to cut the tail off the liabilities. The big debate is how expensive or not buy-outs actually are.
I would argue that a buy-out is the most expensive option. However, it is an immediate and certain option, a type of risk-free option.
aiCIO: You’re paying to get rid of the pain.
Wilson: Yes.
Fogarty: And you’re paying a lot.
Wilson: I estimate the cost of an annuity buy-out is approximately 3% to 5% more expensive than managing the plan down over time. I should note that this premium is highly plan-dependent and assumes the liabilities are discounted using the PPA Spot Curve.
Therefore, the fundamental decision plan sponsors need to make is one of certainty of execution at a higher price—buy-outs—versus managing the plan down at a potentially lower ultimate cost while maintaining various risks, such as investment, longevity, and business opportunity cost—i.e. a distracted management team.
Many plan sponsors today are currently not motivated to write the big check required to execute a buy-out. As rates rise and funded ratios improve, it is likely a lot more buy-out activity will occur, but not as much as many market participants are calling for in my opinion.
aiCIO: What do you see for the future of the LDI business itself?
Wilson: Over the past three years, the acceptance and adoption of LDI has skyrocketed. So, the educational phase has essentially ended. Currently, almost nine out of ten plans are either practicing LDI to some degree or intend to adopt an LDI program.
If you’ve closed or frozen your plan, you have officially made the decision that you’re out of the pension business. You just haven’t acted on that yet if you haven’t implemented LDI.
I think the next five years will be quite fruitful for bona fide LDI providers. We project about $1 trillion of demand for long-duration bonds/derivatives over this time horizon.
aiCIO: What do you hear from plans who are closed or frozen, but don’t think in LDI terms?
Wilson: Most frozen and closed plans are very willing to adopt LDI. Those who are hesitant are generally significantly under-funded and/or concerned about extending duration in the face of rising rates.
aiCIO: LDI certainly seems to have won the argument.
Wilson: Yes, particularly as the case for LDI has been proven over the last dozen or so years. The volatility of return-seeking strategies, whether they are equities or alternatives, and the fact that they’re not correlated to pension discounting rates, has caused plan sponsors across the country a lot of pain in terms of funded ratio and contribution volatility. For example, over the past seven years, more than a half of a trillion dollars of contributions have been made to pension plans in the United States.
