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A research paper examines three levers that DB plan sponsors can use to enhance portfolio outcomes in a low-interest-rate environment.

By Rebecca Moore editors@strategic-i.com | October 04, 2017
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A research paper published by the Pension Research Council examines three levers that defined benefit (DB) plans can use to enhance portfolio outcomes in a low-interest-rate environment: increased contributions, reduced investment costs and increased portfolio risk.

Researchers from Vanguard note that, “As fixed-income yields hover near historic lows, defined benefit pension plan sponsors must grapple with a rise in the present value of their plan liabilities and a fall in prospective investment returns.” Their asset class projections find a portfolio with a 60% allocation to global equities and a 40% to global fixed income generated an annualized 5.5% return from 1926 through 2016. However, they estimate that, for the 10 years through 2026, the median return for the same portfolio will be about 2 percentage points lower.

In a Pension Research Council white paper, “Getting More From Less in Defined Benefit Plans: Three Levers for a Low-Return World,” researchers contend that an increase in contributions is the most reliable strategy to improve DB plan funding levels. While the decision to increase contributions must compete with other uses of corporate cash flow, such as capital investment and returns to shareholders, the benefits to active and retired participants is clear.

In its analysis, using certain assumptions, the researchers find that annual contributions of $1 million raise the probability of reaching full funding from 47% to 66% over a 10-year period. Contributions of $2 million per year increase the probability to 81% and also increase the plan sponsor’s flexibility to implement liability-driven investment (LDI) strategies that limit the plan’s vulnerability to changes in interest rates and asset and liability values.

Reducing Costs 

The Pension Research Council paper notes that retaining the services of in-house or external portfolio managers has a cost. Reducing costs has a positive impact on the future value of a portfolio.

For example, in the case of a portfolio with an initial value of $100 million, assuming a rate of return (ROR) of 7% per year before fees, the researchers found that, net of 100 basis points (bps) in annual fees, the portfolio’s value would grow to about $178 million over 10 years. If fees were reduced to 50 bps, the portfolio would have accumulated an additional $9 million in assets. Over 30 years, annual savings of 50 bps would translate into more than $90 million in additional assets.

NEXT: Increasing Portfolio Risk