Is it time to strategically re-risk your defined benefit plan?
We are in the midst of market turmoil unlike anything we have experienced in recent memory. Equity markets have dropped in value and continue to make daily routs or rallies, with the S&P 500 falling as much as 30% at one point since the beginning of 2020. Defined benefit ("DB") discount rates have been on a roller coaster ride, starting the year at historical lows near 3.0%, then dropping nearly 80 basis points (bps) by March 9 on falling treasury rates, only to leap 150 bps higher from the low point on spreads that at one point nearly tripled during the year.
This has been an intensely volatile period, and many DB sponsors are considering what (if anything) to do with their plan's asset allocation. In another recent blog post, we made the case for using your strategic policy as an anchor for decision-making (including rebalancing), rather than making significant tactical bets during this time of uncertainty. However, if the underlying plan sponsor needs and circumstances have changed materially, some may want or 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 while the current economic environment is unsettling, 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.
- 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 expected performance of individual 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 horizon. This will help to guide risk and reward tradeoffs the sponsor is willing (or able) to take.
All these factors are of course subject to change. For this reason, we recommend refreshing the strategic review analysis about every three years. Occasionally, a substantial change to one of these factors occurs. This may necessitate a comprehensive review ahead of schedule that could lead to re-risking. In this context, re-risking is an increase in exposure to return-seeking assets. Note, however, that this does not have to lead to an increase in overall plan surplus risk (i.e., risk for the combined assets and liabilities), 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 anything needed to fill the funding deficit. Typically, 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 does not necessarily mean 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 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 sponsors 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 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.
|ASSET MIX||FUNDED STATUS||RETURN-SEEKING ASSETS||LIABILITY-HEDGING ASSETS|
Many glidepaths are set up as “one-way”, meaning that they are not designed to revert back to prior mixes. Glidepaths are done 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 make an immediate impact on reducing contribution requirements. 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-/2009, 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 a number 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 taken to generate return, which in turn helps to (hopefully) 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 duration of the physical fixed income, or using synthetic treasury exposure.
As a result, to maintain or improve the liability hedge while re-risking, some plan sponsors (if they haven't already) may need to break the mold of simply matching LDI duration to liability duration with long credit, and instead adopt a hedge ratio target range as part of the glidepath that gives flexibility for the LDI duration to extend, and treasury to credit composition to adapt, as needed to manage surplus risk. Moreover, sponsors should be considering risk from a total plan perspective, including interest rate, spread and equity risk relative to liabilities. This will not be possible for all plans, and in those cases plan sponsors will need to understand the extent to which they are increasing the surplus risk alongside the equity risk.
Re-risking is a likely consideration for sponsors hoping to take the minimal amount of risk to achieve their required return, but who could tolerate more risk if needed. For those sponsors, with a higher return requirement now, re-risking may be a sensible policy consideration. 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 should be avoided. While the recent market chaos has 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 ought to engage their DB investment strategist to consider trade-offs associated with adopting a new strategic asset allocation.