The 2022 List Issue, Part 4: 11 things every DB plan sponsor should consider
In an unstable market and regulatory environment, it’s nice to know there’s still a few things left unchanged.
Such as our advice on best practices for defined benefit (DB) plan sponsors.
Take a bow if you had that on your 2022 bingo card.
All kidding aside, over the last few years, we’ve consistently advocated how important it is for pension plan sponsors to know where they are in the life cycle of their plans. With this in mind, we noted in 2021 that a contribution/funding policy was better served by looking beyond the year’s minimum regulatory-required contribution. We said plan sponsors should have instead focused on the best ways to allocate long-term costs not covered by investment income to the corporate budgeting process, if stability was desired.
This year, we kick off our top-10-plus-one (OK, fine, 11) list by beating the drum once more on the real implications that your defined benefit plan’s time horizon has on investment strategy.
We’ve also carved out a portion of 2022’s list to the development of a more comprehensive glidepath, given the importance of knowing where your DB plan is headed. For corporate plans today, most glidepaths are prescriptive on how the allocation to hedging assets and target hedge ratios change as funded status changes. We believe that your actual glidepath has consequences beyond just these two factors, and may be a function of more than just your plan’s funded status.
This year’s list wraps up with a closer look at total surplus risk management. In 2020, we emphasized the importance of surplus risk management, identifying hedging portfolio structure and diversification as some of the key components. In last year’s edition, we were even more granular about the characteristics of optimal hedging composites, active risk and the impact of volatility on the path of returns. This time around, we double-down on the breadth of factors to consider when addressing total surplus risk management.
With that, let’s cut to the chase. Here are the top 11 things we believe plan sponsors should consider in 2022 when incorporating each of these three aspects into their pension systems.
1. Don’t ignore liquidity needs as your plan matures. When assets and liabilities shrink as the plan matures, they do so at increasing rates, putting pressure on the need to source cash for benefit payments. Where and how do you accommodate that?
2. Don’t dismiss alternative investments. Per our first point, make sure you have enough liquidity, but once you do—and you have additional room for growth assets—consider the many favorable characteristics of alts, including private capital, hedge funds and real estate.
3. Be aware that major events accelerate the best laid plans. Plan spinoffs and annuity purchase activity are often planned for well in advance, and sometimes they are accelerated by unforeseen corporate catalysts. When the unforeseen happens, be ready for their implications on your comprehensive glidepath.
4. Fees. As your hedging assets go from 40% to 50% to 70% or more of your total allocation, your growth assets are—by relatively easy math—going from 60% to 50% to 30% or less. What does that do to effective fee rates, where fee schedules are asset-based? Does this have implications on which and how many managers are appropriate for your growth composite?
5. Complexity (as in, number of line items). Similar to the impact of movement down a glidepath on fees, it will almost certainly be important at some intervals to rationalize the number of managers employed. While a five-manager composite makes sense at $100 million of assignments, it may not at $30 million.
6. Alpha. When growth is 70% of your total portfolio and alpha expectations are, say, 100 basis points (bps) for active management, that 70 bps of total incremental return is worth the time and effort to manage the complexity. When growth is 20%, and alpha is the same or slightly less (because you have fewer, more diversified managers), that 20 bps or less of incremental return needs to be reassessed against the time and effort required to manage the complexity.
7. Completion management. The ability to use overlays solves many problems that crop up as you move down your comprehensive glidepath. A completion management function addresses many needs, including the need for liquidity, nimble rebalancing, capital-efficient hedging and the shifting of dependence on alpha to factor (or the addition of factor positioning).
Total surplus risk management
8. Low volatility. Not only is low volatility a viable factor exposure in its own right, it’s nicely aligned with a comprehensive glide path that is de-risking.
9. Diversifiers. Much can be learned from looking at how the best insurance companies in the market manage their reserve assets (think of this as a template for your hedging composites). In a low-spread environment for investment-grade public credit, we believe the inclusion of investment-grade private credit makes a lot of sense from diversification, risk mitigation and yield enhancement benefits.
10. Capital efficiency. We continue to be advocates for addressing dollar duration as efficiently as possible. This means STRIPS (Separate Trading of Registered Interest and Principal of Securities), and—for those with significant need for growth assets—often interest rate derivatives.
11. Factors. Much of our research in the risk make-up of actively managed growth portfolios points to persistent biases to (and away from) factors. We think some of these are in the right direction and some in exactly the opposite direction. We believe that managing your factor exposure—either to complete an active composite, or as a replacement for active risk (see above #7)—is prudent. As such, we incorporate these into the portfolios we help our clients build.
The bottom line
Is this the most disruptive list in the world? It’s not. We know that. So do you. It shouldn’t be. But imagine how sweetly a plan might hum if it got all 11 of these things right. Our job as strategic partner with our clients is to keep them on your radar and offer support in making them happen. Just getting the basics right is hard work.