Abstract:

For the second time in less than 8 years, falling stock prices have severely damaged the health of our defined benefit pension plans. Corporate and public pension plans as well as the Pension Benefit Guaranty Corporation face severe funding deficits and plan freezes and terminations abound.

This situation could have been avoided if plan sponsors and investment managers would have embraced the concept of liability driven investing. By matching liabilities with correlated fixed income assets, pension plans could have avoided their current large funding deficits.

While the risk reducing effects of LDI are well-known, plan sponsors, investment managers, and consultants often cite the lower return potential of fixed income assets as the main obstacle to finally adopt LDI strategies. Because of their long investment horizon, it is argued, DB pension plans can reap the benefit of the equity risk premium if they just stick to equity based investment strategies.

I will argue that this argument is flawed and constitutes a common fallacy. In a first step, I will show that a defined benefit pension plan following an immunized fixed income strategy can have lower long-term funding costs than if it were to follow an equity-based investment strategy. This is true even if stocks outperform bonds over the relevant time horizon.

In a second step, I will argue that past and regulations as well as investment behavior tend to turn this theoretical possibility into the standard case. I will present empirical evidence that the requirements to convert an eventual equity risk premium into lower funding costs are often violated in practice.