Is it time to strategically re-risk your defined benefit plan?
The first half of 2022 was a challenging time for portfolio returns. Nearly every asset class experienced negative year-to-date returns. As of June 30, global equities were down about 20%, the Russell 3000 technology sector down 30% and the U.S. aggregate bond index down 10%. For defined benefit (DB) investors, skyrocketing discount rates, which at times have risen nearly 200 basis points (bps) during the year, have dampened the impact on funded status to some extent, but the asset losses have been so severe that most have still seen their funded status decline year-to-date.
During this volatile period, DB sponsors may be considering what (if anything) to do with their plan’s asset allocation. In this blog post during the throes of COVID-19, we made the case for using your strategic policy as an anchor for decision-making (including rebalancing), rather than making significant tactical bets during time of uncertainty. However, if the underlying plan sponsor circumstances have changed materially, some may need to update their strategic asset allocation.
In this blog we will cover what circumstances may lead to a new strategic policy. Note, however, that it is usually not prudent to make long-term strategic asset allocation decisions in the midst of a crisis. Waiting for the dust to settle a bit will reduce the odds of being too reactionary to short-term gyrations in the market. It is important to acknowledge that in robust, stochastic (randomized) asset-liability modeling used to develop strategic asset allocations, these types of scenarios are an acknowledged—if extreme—possibility.
We are not attempting to describe tactical, short-term shifts in asset allocation based on day-to-day changes in the market (though there may still be a place for these as well within a portfolio), but rather considering the factors we normally review in the context of total portfolio strategic asset allocation. Few (if any) other choices made by a plan sponsor will have a more significant impact on achieving their plan-related goals than having an appropriate asset allocation in place.
Strategic asset allocation reviews
Let’s review the plan and sponsor-specific factors we consider as part of a strategic review in setting the strategic asset allocation. We cover these in detail in this paper. They include:
- Liability characteristics, including funded status and liability duration
- Existing investment policies, as defined in the IPS, such as investment beliefs, glidepath strategies and hedge ratio objectives
- Capital markets outlook, which will influence the expected performance of individual asset classes and their correlation with other asset classes
- Plan sponsor risk tolerance, or in other words, how sensitive the plan sponsor is to downside risk versus the potential for equity growth that could offset future contributions
- Plan sponsor goals and objectives, or where the sponsor hopes to see the plan in five to 10 years, and the intended contributions over that time horizon. This will help to guide risk and reward tradeoffs the sponsor is willing or able to take.
All of these factors are subject to change over time. For this reason, we recommend refreshing the strategic review analysis about every three years. Occasionally, a substantial change to one of these factors occurs, and this may necessitate a comprehensive review ahead of schedule that could lead to re-risking or de-risking.
In this context, re-risking is an increase in exposure to return-seeking assets to generate additional return. This does not have to lead to an increase in overall plan surplus risk (i.e., risk for the combined assets and liabilities, or funded status), which is also heavily influenced by the composition of liability-hedging assets.
Changing return needs
We cover required DB returns in detail in this paper. The most significant return needs for DB plans are interest cost, service cost and shortfall amortizations (i.e., return needed to fill the funding deficit). Typically, for an underfunded plan, return alone will be insufficient to meet all these needs; contributions will be needed as well. Moreover, even averaging a targeted return over time will not necessarily lead to intended outcomes since the path of returns matters. Likewise, higher average returns do not necessarily translate to lower contributions.
Examples of events that could increase return needs include:
- Significant drift from intended glidepath. Sponsors that have progressed on a glidepath but have now fallen significantly from the most recent trigger point (e.g., fallen at least 10% since the last trigger) may need to re-evaluate and potentially recast the glidepath, even if the glidepath was originally intended to be one-way. A variety of factors, such as an equity market collapse, significant assumption changes, or declining discount rates can lead to this scenario.
- Plan mergers or plan splits have become more common and often have a significant impact on liability characteristics if one of the plans has a different funded status, time horizon or benefit accrual policy.
- Annuity purchases—and to a lesser extent, lump sum transactions—can materially increase the size of service cost as a portion of liabilities. In addition, for underfunded plans, these transactions may reduce the funded status of the plan.
Other events such as changes in plan sponsor objectives and risk tolerance levels could also lead to re-risking. Note that plan freezes and closures are also significant events, but they usually reduce return needs and lead to de-risking.
Glidepaths deserve a closer look. Let’s consider the following basic de-risking glidepath for a frozen plan. Over the last couple of years, this plan has progressed along the glidepath, reducing exposure to return-seeking assets, to asset mix 2 with a funded status above 85%. However, due to a combination of actuarial assumption changes and negative equity performance, the funded status has fallen to 75%, far below the beginning of the glidepath originally intended for asset Mix 1.
Many glidepaths are set up as one-way, meaning that they are not designed to revert to prior mixes. Glidepaths are set up this way primarily to avoid excessive trading as funded status routinely peaks and dips day-to-day. However, when a plan has drifted far below the intended target, the required returns can change, and a higher long-term return could be beneficial to help reduce expected contributions.
Note, however, that increasing return-seeking assets will not necessarily improve return over the short or medium term, and sponsors should not expect this adjustment to have an immediate impact on reducing contribution requirements or filling the funding deficit. For sponsors where a higher return is not a priority in isolation, re-risking may be less attractive.
We have seen large drops in funded status before. While DB glidepaths were not generally used during the Global Financial Crisis in 2008-09, in 2014 most plan sponsors experienced a 5-7% drop in funded status after liability mortality was updated. This caused us to re-evaluate strategic asset allocation for most of our clients, and some of our clients made adjustments for it.
What type of risk are we reintroducing?
DB plan sponsors carry two main risks—equity risk and interest-rate risk. Equity risk is used to generate return, which in turn helps to (ideally) reduce future contribution requirements. Interest-rate risk is inherent in all corporate DB plans due to the nature of liability calculations on a mark-to-market basis (used in accounting and PBGC calculations). It is a risk we try to hedge to the extent possible as we don’t expect an accompanying long-term return.
In re-risking, as mentioned before, we are typically attempting to generate additional return, not trying to increase overall surplus risk. To the extent possible, sponsors should adopt a strategy that maintains or improves the liability hedge. This would most likely be accomplished by extending the fixed income duration to compensate for reduced physical fixed income exposure, or using synthetic treasury exposure to increase duration.
Re-risking may not be a good option for sponsors hoping to minimize risk. It is more appropriate for those that could tolerate more risk if needed. For sponsors already at the limit of their risk tolerance, the reduction in funded status could actually lead to further de-risking in light of market events.
Since strategic asset allocation is intended to meet long-term objectives and to stay relatively stable, frequent and overreactive changes to the policy should be avoided. While the recent market downturn may have hurt funded status for many sponsors who have prioritized return seeking over risk management, wholesale changes to asset allocation may not be needed immediately. But as markets calm and time can be devoted to strategic analysis, sponsors with changing return needs may need to engage their DB investment strategist to consider trade-offs associated with adopting a new strategic asset allocation.