Pension funds that used so-called liability-driven investment (LDI) strategies outperformed funds with traditional asset allocations in 2008 by a significant margin, according to Watson Wyatt, a global consulting firm.

LDI strategies seek to reduce pension funding volatility by aligning investments more closely with plan liabilities (in the form of future payments to retirees). Typically, LDI emphasizes the use of long-duration bonds, liability hedges and asset diversification while lowering exposure to equities.

Portfolios using LDI strategies likely had returns in the range of negative single digits to break-even, while traditional asset allocation strategies likely yielded 20 to 30 percent losses or more.

A set of hypothetical portfolios - one LDI and one traditional - constructed by Watson Wyatt in December 2007 and tracked on a monthly basis demonstrates the sharp difference in returns. For 2008, the hypothetical LDI portfolio broke even, while the traditional portfolio suffered a 25 percent loss.

"New accounting and pension rules - and the desire for more predictable returns - have prompted some companies to adopt LDI strategies in recent years," says Carl Hess, global head of investment consulting at Watson Wyatt. "LDI served those companies well in 2008.

"However, most companies are still using traditional allocations or are in the process of phasing in LDI strategies. Unfortunately, options are more limited for now, as hedging opportunities have dwindled with the credit crisis, and market volatility makes big investment moves risky."

The emphasis on long-term bonds and liability hedges paid off handsomely last year - the long duration bond benchmark was up more than 8 percent in 2008, and interest rate swaps performed even better, with some returns in excess of 30 percent.

But asset diversification worked less well. That's because most securities - U.S. large and small caps, international equity and even real estate and hedge funds - declined in value together. However, there was some value in diversification, as alternative asset classes generally did not have the same magnitude of declines and hedge funds continued to aid risk control.

"Although the liability hedge worked in 2008, last year's high positive returns on swaps and long bonds will not likely continue going forward," said Mark Ruloff, director of asset allocation at Watson Wyatt. "Despite this, the full range of liability hedging options has gained new credibility, and the recent financial turmoil has proved that its appropriate use has a definite value in controlling and managing risk."