Susan Mangiero recently responded to our post of last week on a new reporting trend in retirement plans, one that calls for a more accurate reflection of liabilities and surpluses in a single year rather than "smoothing" gains and losses over longer periods. The back-and-forth has us thinking it may be useful to provide more clarification on liability-driven investing (LDI) and mark-to-market accounting.

First off, let's be clear: When we refer to mark-to-market liabilities, it's not necessarily accounting requirements that are of central concern. Financial Accounting Standards have been instrumental on the financial reporting side of things, but it's really the Pension Protection Act that is central here, both because it introduced mark-to-market on pension funding and also because it makes LDI viable. The market crashes in 2008 and, previously, in 2001-02 verify the primacy of LDI. Without mark-to-market--which entails valuing liabilities based on current market interest rates/yields--LDI cannot exist. In this sense, mark-to-market enables LDI to work. Whle not a perfect congruence, reducing funding volatilities will also reduce accounting volatilities. Since funded and accounting rules require mark-to-market, LDI can be implemented with either as the primary cost metric.

Backing up even further, a primer may be helpful. For retirement plan sponsors, mark-to-market accounting tends to introduce risks, chiefly related to interest rates. It's a factor many of them have never had to deal with before. In the simplest terms, the goal of LDI is to address those risks. The strategy is simple enough, calling for as close a match as possible between asset and liability returns over the course of a year. If asset returns match liability returns, then the funded level at the end of the year will be the same as at the beginning of the year, all things being equal. By operating on such an even keel, funded status volatility and thus contribution requirements are kept as manageable and predictable as possible.

It means, for retirement plan sponsors, that they are able to work with more clarity on an ongoing basis regarding their liabilities. LDI requires retirement plan sponsors to extract performance metrics from their liabilities and use those metrics to guide buying the right Pension Protection Act (PPA) bonds. With the right bonds, asset returns mimic liability returns, leaving funded status essentially insulated from market gyrations.

Effectively managing funded status is a key sign of a prudently managed pension plan. Because there is a causal arrow that links changes in funded status to changes in required cash contributions, LDI enables retirement plan managers to control funded status volatility and thus, simultaneously, contribution volatility.

The result? Everyone is more confident, secure and happy.