"Plan sponsors are going beyond easy investment solutions to considering, and many cases implementing, more exotic approaches," says Phil Kivarkis, an investment consultant at Hewitt Associates.

These approaches include liability driven investing, incorporating swaps and derivatives, a departure from past practices that relied primarily on extending the duration of bonds. Beyond this, there is every indication that plan sponsors are becoming aware of techniques and asset classes pioneered by endowments, including a greater use of alternatives and global diversification, all once considered exotic, but perhaps no longer.

Driving these new approaches are regulatory changes. Last year was marked by extensive planning and talk by sponsors attempting to grapple with the impact of the PPA and FASB Phase One rules on their pension plans. Faced with stiffer funding requirements, a move to market accounting with reduced smoothing, and a migration of pension deficits onto the balance sheet, sponsors began to seriously examine any asset-liability mismatch.

So what is the story for 2008? "Plan sponsors are beginning to finally get there and move beyond just the planning mode," Kivarkis says. Though some plan sponsors are still relying on simpler strategies from the past, others are at least thinking about global investment strategies developed in the endowment investing world. An open question is whether the credit crunch will cause sponsors to step back from these new approaches - at least temporarily- or if it, in fact, will propel movement in the "exotic" direction.

Low-hanging fruit

The heart of the problem facing plan sponsors is the disconnect between liabilities, which are interest-rate sensitive, and assets, which don't necessarily have the same interest-rate sensitivity. The simplest solution, and one widely deployed in 2007 and earlier, was to try and synchronize the fixed-income portion of the portfolio to liabilities. This did not mean a change in overall allocation to fixed income. Instead, it was a change to exposure within the allocation, with a greater use of long duration bonds. In the past year, this has been a cost savings move as well. This combination of a better match and cost-savings has made this a "no brainer" for sponsors- and a wildly popular one. Surveys by Hewitt Associates have found 90% of plan sponsors have extended the duration of their bond holdings.

This approach, while appealing in its simplicity, has limitations. It is at best a partial solution because it doesn't necessarily address the mismatch on the equities side. Additionally, there is concern that demand for long-duration bonds could outstrip supply. In the U.K., this has already happened, resulting in an inverted yield curve. So far, in the U.S., the problem is more theoretical than real, as supply in long duration bonds has grown to meet demand. Nonetheless, sponsors are looking for other approaches that more precisely match assets to liabilities.

LDI: the new "new thing"

The big story in DB investing remains liability driven investing. "I doubt there is a single client not interested in LDI at this time," says Bill McHugh, chief pension strategist at J.P. Morgan Asset Management. "Initially, smaller plans were slower in buying into an LDI approach, but this is no longer the case." This is reflected in a change in allocations. Whereas three years ago, McHugh says, it wasn't unheard of for plans to have 60% to 70% of assets in equities, today a typical plan (large or small) might have reduced its equities to only 30% of a portfolio, with the rest consisting of fixed income and alternatives.

What is LDI? Definitions vary by consultant and sponsor but share certain broad themes. In essence, the goal is to invest with an eye toward matching plan liabilities, rather than just using a traditional benchmark, such as the S&P 500, to judge performance. Extended bond durations are a component, but only part, of a much broader strategy.

Mark Ruloff, director of asset allocation at Watson Wyatt, says, "LDI in our definition is made up of three components. The foundation is a liability hedge, matching assets and liabilities. The second is diversified beta. And at the top level is persistent alpha."

Taking the last concept first, alpha, or market beating performance, is an appealing yet elusive prospect for many sponsors. It means plans can improve their funded status through superior returns without having to increase contributions. But finding managers who can persistently deliver alpha is far from an easy task; it demands a real commitment from a sponsor, and even then there are no guarantees. Ruloff warns it requires heavy corporate governance, with a team in place to closely monitor manager performance.

In terms of the asset-liability matching component, plans have many approaches they can utilize. Beyond moving to long-duration bonds, plans can reduce their allocation to equities and increase their overall allocation to fixed income as well as alternatives. Or, they can use interest-rate swaps to further reduce interest-rate risk. In extreme cases, plans can completely immunize their liabilities, relying entirely on a fixed-income portfolio, but this is only an option for fully funded plans. The optimal strategy depends on the plan's funded status and other characteristics. For a fully funded or frozen plan, a portfolio heavy on real bonds makes sense because there is no need to grow assets to improve the funding ratio. But for an underfunded or ongoing plan , the inclination might be to "hedge out interest rates using swaps, while still keeping the return-seeking assets to improve funding," according to Ruloff.

The credit crunch, however, may have caused a change in plans, at least for the short run.

"The bond pricing dislocation, combined with a very uncertain economic environment, has caused people to slow down or stop buying physical bonds," says Jeff Schutes, who leads Mercer's investment consulting business. Plans may instead turn to the swap market, but the near-collapse of Bear Sterns is indicative of the real risks and pervasive climate of fear in this market. Says Schutes, "There is now a tremendous amount of diligence and an abundance of caution." However, he also points out clients typically step into these strategies and allocations slowly over time. Even a plan that wants to move to a 40% allocation to long-duration bonds doesn't tend to do so overnight, mitigating the impact of the current market dislocation.

Regardless of these concerns and risks, LDI can pay off. According to a 2008 analysis from Watson Wyatt, a typical LDI strategy (meaning a movement toward greater matching, but not complete immunization) would have outperformed a traditional strategy by 1% in 2007. In the first quarter of 2008, it would have outperformed by 3% (though both approaches would have seen a decline in the value of assets in 2008).

Movement toward alternatives

In addition to increasing the duration of bonds and tightening assets to liabilities through swaps, plans are venturing into alternatives, investing in hedge funds and private equity. Data from Greenwich Associates U.S. Management Survey (Feb. 2008) shows more than half of U.S. pension plan sponsors now invest in alternatives. Some 54% of plans surveyed invest in private equity, 44% use hedge funds, and 12% have commodity allocations.

Rodger Smith, managing director at Greenwich and one of the report authors, points out, "The long-term trend is for sponsors to use alternatives much like foundations, and this trend is here to stay." However, as Smith acknowledges, plan sponsors are not exactly early adopters in this area; foundations have been investing along these lines since the 1990s. This means sponsors may not get access to the best managers, or they may find certain asset classes are already played out.

Nonetheless, Smith is bullish: "Private equity or buyout funds could clearly benefit from a corporate plan as a client." A pharma corporate parent, for example, could add expertise and knowledge to a pharma venture fund. Given these added benefits sponsors can bring to buyout or venture partners, Smith feels "clearly sponsors are not early to the game, but they are not too late either. But they must select managers who add value."

Newer betas

On the opposite end of the spectrum from active management like hedge funds or private equity is passive management, using beta exposure. "Beta" in this context commonly refers to broad market returns using an ETF or index funds. Additionally, it typically implies investments in specific markets: U.S. equities in various guises or U.S. fixed income.

However, newer betas have been developed that go well beyond exposure to U.S. public markets. They have changed dramatically to include foreign equities, REITs and new asset classes, such as timber. Steven Bozeman, head of DB outsourcing at Barclay's Global Investors, says, "Investing only in U.S. equities or bonds is a legacy of a historically limited number of asset classes. Today you can get exposure to new markets that were, in the past, illiquid." Bozeman calls this "smarter beta."

Investing in markets such as infrastructure or real estate was driven by endowments. But today, through these new betas, these asset classes are available in liquid, publicly traded form, and sponsors can easily access them. The result should be a better diversified portfolio, less dependent on a single market. Bozeman argues plans can therefore increase their returns while reducing their risks: "The new betas release constraints, giving you more asset classes from which to build an asset portfolio with the highest return with the least risk."

Inflation-linked asset classes

Matching asset to liabilities is mostly an exercise in managing interest rate risk. But for public plans with cost of living adjustments (COLAs), inflation is a worry as well. Meanwhile, Andrew Junkin, managing director of Wilshire Associates, says benefits are tied to wages, which are tied to inflation - so having a portfolio that includes inflation-linked asset classes should be of interest to any ongoing plan. Plan sponsors may not be familiar with some of these asset classes, which are only now making inroads from the endowment space.

Infrastructure: Toll roads, power plants, hospitals. Investing in these assets provides a great inflation hedge, as well as great returns (8% on average, but it can go much higher for new projects). Moreover, the returns, from say, a toll road, are perpetual in nature, making then a good match for an ongoing plan. Though infrastructure is attracting a huge amount of attention, Junkin says for now most plan sponsors are "just dipping their toes in" the asset class.

TIPs. Using inflation-protected bonds, such as TIPs, is another strategy for the inflation-conscious. However, Junkin says the returns from these instruments are too low to make them attractive right now.

Commodities. Commodities, such as oil and wheat, have experienced phenomenal gains recently- so large they raise concerns that commodities are experiencing a bubble. Nevertheless, they remain a good inflation hedge with a low correlation to other asset classes. Wilshire feels recent returns are anomalous, but a basket of commodities remains useful to the long-term investor concerned about inflation.

Timber/farmland. Timber, too, is inflation-linked. Money may not grow on trees, but timber (and to a lesser extent, farmland) can produce handsome long-term returns, good for those with a long investment horizon. However, Junkin notes, some endowments and plans have been reducing their allocations, since expected returns have come down as more investors move into this asset class.

Sponsors' experiences

These new ideas and asset classes sound fascinating in theory. But what are things really like in practice? What lessons can be learned when sponsors try to implement these new ideas?

Alcatel-Lucent's experience with changing its investment strategy is illuminating. The company runs two DB plans in the United States. Both are in a good funding situation, with the $19 billion management plan at 118% funded status, and the $17 billion union plan at 158% funded status. But the sheer size of these plans - $36 billion - easily dwarfs the market cap of the parent company, which is only 8 billion Euros (approximately $12 billion). This is a clearly a big issue for Alcatel's board of directors. Though a French board and a U.S. plan, they became fiduciaries, making asset allocation decisions because they were such a significant call on the capital of the parent company.

Mark Gibbens, Alcatel-Lucent's Paris-based corporate finance and investment officer, explains, "We needed to reduce volatility. The focus is less on asset returns and more on interest rate matching, which has changed the way we invest." The resulting strategy is something that closely resembles LDI, though Gibbens doesn't use that term.

The first step, taken in 2002, was to extend the duration of fixed income. But that only matched 25% of the interest-rate exposure. The more dramatic change was in 2006: The plan sold off 8.1 billion Euros in equity, with a further multibillion dollar move out of equities in November 2007. This created plans that were perfectly interest-rate matched. The new allocations now look something like 10% equity, 15% alternative, and 75% fixed income. Says Gibbens, "Through surplus management' and liability-asset matching, both of which involved reducing equities, we took the interest-rate and volatility risk off the table."

If the plan hadn't sold off the equities in November of last year, it would be dramatically worse off- by $1 billion. Gibbens is modest about the money he saved, emphasizing he isn't running a hedge fund. Instead, it was a carefully planned shift based on a thought-out investing framework: "Our job is to do this for the benefit of participants."

Alcatel-Lucent's situation, given the size of the plan, both in absolute terms and relative to the parent company, is not representative of smaller plans, with, say, less than a billion dollars in assets. These plans may have moved from an asset-only investment environment to one in which liabilities are a consideration, but they still might not have formally embraced an LDI strategy or shifted heavily to fixed income or alternatives.

"Sponsors need to feel pain, and they haven't all felt the pain yet," says Hewitt's Kivarkis. Some, he admits, have just shrugged their shoulders about the FASB Phase One balance sheet reforms. But this low-pain environment is about to end, with the looming FASB Phase Two reforms. Expected in 2012 or earlier, these will directly impact the income statement.

In practical terms, insiders see 2008 bringing further picking low-hanging fruit, such as use of long-duration bonds and greater diversification of asset classes. LDI incorporating interest rate swaps, as well as use of alternatives, will remain popular as well. Going forward, these trends are likely to continue and perhaps accelerate. Says Kivarkis, "In anticipation of FASB Phase Two accounting changes, the market will continue on the LDI path and more use of exotics, but at a greater clip."