The frozen plan equation – don’t forget the denominator
Earlier this year, we updated our Frozen Plan Handbook--our guide for plan sponsors who manage frozen pension plans (or who are considering freezing their plans). As the interest rate and return environments continue to shift this year, it seems like a great time to revisit the role of the denominator in the fundamental equations governing frozen plans.
The nature of frozen plans--without benefit accruals, and with resulting shorter duration liabilities--opens the door to more precise liability hedging. With rising rates equating to lower liability values, one of the key denominators in managing your hedge ratio shifts:
The ratio of the duration of the assets (i.e., the sensitivity of the asset portfolio to changes in interest rates) to the duration of the liabilities, in combination with the plan's funded status and percent in LDI (liability driven investments), is a good way to proxy the hedge ratio or the percentage of liability changes due to interest rate changes covered by plan assets.
To improve the interest rate hedge, sponsors generally have three levers at their disposal:
- Contribute to the plan to improve funded status.
- Increase overall allocation to liability-hedging assets.
- Increase the duration of their liability-hedging fixed income.
In this period of rising interest rates, managers of frozen plans will want to be sure their hedge ratio is consistent with both their capital market views and their investment policy, rather than a residual of past allocations.
2. Liquidity planning--the structural denominator effect
Managing a frozen plan usually comes with a shortened time horizon (whether through lump sum windows, annuity purchase transactions, or the natural roll-off of benefit payments year after year). The resulting persistent cash outflow requires managers of these plans to pay closer attention to liquidity. If the inability to quickly or easily sell illiquid assets forces the use of more liquid assets to be used for cash outflows, there is a risk that their resulting larger proportion of remaining assets violates policy ranges. We refer to this as the structural denominator effect.
Consider the consequences of illiquidity in the numerator when the denominator shrinks:
By planning ahead and anticipating the likely future development of the fund value, plans can make appropriately sized commitments to illiquid assets and avoid overallocation a few years down the road--a condition that can be difficult to remedy.
For frozen plans, the standard performance question of, did our managers beat the benchmark? should take a back seat to the question, did the numerator keep up with the denominator efficiently, and within the risk budget expected?
Performance reporting that compares a portfolio's returns to an asset class benchmark will always be essential, but is only one of the factors that causes funded status to change. Not only can we track the progress of funded status daily, we can provide attribution to the primary sources of gain and loss:
- The impact of changes in interest rates, both nominal and credit-based. Most pension plans have greater exposure to interest rates in their liabilities than in their asset portfolios, so a rise in interest rates tends to help funded status, while a fall (or even the absence of a rise) tends to hurt.
- The impact of changes in equity and other financial markets. Most pension plans invest in equities and other return-seeking assets, so the performance of those markets affects funded status.
- The impact of portfolio performance compared to a policy benchmark. Due to the effects of active management decisions, actual portfolio returns generally differ from policy benchmark returns. Isolating this effect is important in evaluating investment managers' performance.
Essentially, reporting needs to capture high-level progress, and also to attribute that progress (either positive or negative) to the various sources of gain and loss, tracing the impact of each plan management decision. This enables effective decision making when considering our fourth major impact on the denominator ...
4. Risk transfer strategies
The relative size and attractiveness of risks change through time as the nature of those risks shift. Transferring risk accelerates the maturing of the plan: the liabilities that remain will be different from the profile prior to the transfer. Questions concerning the liquidity of assets, the scale of the plan and the denominator effect can be magnified. The duration of the remaining liabilities, however, tends to increase, especially after annuity buyouts.
Consider a starting point for asset allocation policy based on the resulting net position if the risk transfer were funded entirely out of fixed income assets. For example: if the policy portfolio has a 60% fixed income allocation, and 20% of the assets were then used to fund a risk transfer, the remaining fixed income assets would be one half of the remaining total assets, and so the new policy portfolio might move to a 50% fixed income allocation.
The asset allocation policy following such a risk transfer may not fit the new circumstances:
- The remaining liabilities to be hedged may be substantially different, as the duration of the liabilities and other key characteristics will be altered by the risk transfer.
- The makeup of the growth (return-seeking) portfolio may be changed as well.
Once the sponsor has chosen to terminate a plan, it's best review and revise investment policies in light of the time horizon and anticipated changes in order to protect the plan's funded status.
In short, the art of managing frozen plans differs substantially from that of open plans, and calls for close attention to both the numerator and denominator, particularly in times of shifting interest rates, return expectations, and in the context of pension risk transfer strategies. Our Frozen Plan Handbook is a free resource for plan sponsors, and serves as an illustrative guide for those who have already frozen--or are considering freezing--their pension plan.