Fully funded? Maintaining an allocation to return-seeking assets might still be necessary
Some plan sponsors may think the ultimate goal for a fully funded plan would be to move all assets to liability-hedging vehicles. However, if the goal is to minimize surplus volatility, then moving all of your assets may not be the answer. We have found that plan sponsors are generally better off if they keep a small portion of assets allocated to return-seeking investments.
Why are plan sponsors generally better off keeping a small portion of assets allocated to return-seeking investments?
One of the main concerns plan sponsors have when considering their end game is surplus volatility. The more volatile a plan’s surplus, the more likely cash contributions will have to be made to the plan. This is a risk most corporations don’t want to take. When a plan maintains an allocation to return-seeking investments, the probability of the sponsor having to make contributions decreases.
The chart above examines that trade-off between return-seeking and liability-hedging assets for a hypothetical client who is 100% funded.
Risk is shown on the horizontal axis and is defined as the “worst-case scenario” contribution. Reward, shown on the vertical axis, is defined as the average contribution over the 10 year period.
The further the dot is to the right, the higher the chance contributions will need to be made—or the greater the risk is; the higher the dot is to the top, the greater the reward. Like many charts like this, the ideal place to be is in the northwest corner—greatest reward for the least amount of risk.
The chart steps through various allocations between return-seeking and liability hedging investments. On the far right hand side, the portfolio is 100% of the portfolio allocated to return-seeking investments, and not surprisingly, has the highest level of risk. But, a surprising thing does happen as you increase the level of liability-hedging investments—moving down the line to the left on the chart—and that is that at some point, the level of risk turns back and begins to increase again.
A small allocation to return-seeking assets reduces the probability of making a contribution to the plan.
For this hypothetical client, keeping between 10 and 20% in a diversified return-seeking portfolio would actually reduce the probability of making a contribution. We see this same result when looking at actual client examples. As such, most clients who have reached this end-stage level will decide to keep an allocation to return-seeking assets in an effort to minimize contributions to the plan.