Looking at their defined benefit (DB) plan as part of the overall corporate strategy will help plan sponsors determine how to manage assets, says John McCareins, practice lead for DB pension strategy at Northern Trust in Chicago.
Northern Trust continues to encourage plan sponsors to develop an outcome orientation strategy—to see the DB plan as an asset of the company and manage enterprise risk instead of just relying on interest rates to improve funded status, McCareins says. “Our view is, if they focus on their organizational-specific situation instead of trying to guess on equity or interest rates, they will look at how each of three investment ‘buckets’ will work toward the corporate goals and make the portfolio as all-weather as possible.”
The three “buckets” to which McCareins refers are:
- Liability awareness—investing in assets that behave in correlation with the plan’s liability;
- Growth—global equity exposures engineered to manage risk exposure at different points on a funded-status glide path; and
- Diversification—investing to achieve higher yield and lower correlation to the equity markets or interest rates, for example by investing in global real estate, infrastructure or hedge funds.
Plan sponsors should be focused on working assets smarter, not harder, McCareins suggests. The equity markets have continued to show above average results over the past three calendar years, and interest rates are at historical lows: putting the two together begs the question, ‘Do I lean toward fixed income or equity?’ Plan sponsors should view each investment or asset class as contributors to risk and return, and each has a distinct role in the DB plan portfolio, he says.
The theme of working assets smarter not harder is leading to demand in alternative and engineered equity investment strategies, McCareins contends. For example, DB plan sponsors are looking into custom hedge fund programs or engineered equity strategies—what some call smart beta. Northern Trust’s engineered equity strategies are somewhere in between passive strategies, that just seek to replicate an index, and active strategies, that focus on one goal, such as achieving returns. Engineered equity strategies can amplify certain factors and minimize others.
DB plan sponsors should be discussing whether their investment strategies continue to reflect corporate goals for the plan, adds Michael Fischer, managing director and institutional investment executive at U.S. Trust in Charlotte, North Carolina. Is the ultimate goal for the plan termination or keeping it going as a strong benefit? The answer will drive investment strategy.
If plan sponsors want to keep their DB plans going, they must assess what risk they want to take with their plans, Fischer says. For example, they may want to control the risk of a negative surprise; if interest rates go down when they expect them to go up, and they haven’t hedged interest rate risk, they may end up with a greater funding requirement than what fits their budgets.
Consulting firm Mercer says the plan’s funded status may determine the best way for sponsors to deal with low interest rates. For a relatively well-funded plan, the sponsor may want to remove interest rate risk regardless of the rate level, either through increasing the hedge ratio or outright transfer of the risk through a cashout or buyout. For sponsors in a deficit position, moving to a high level of fixed income or extending duration may not be ideal. For some sponsors with good credit ratings, borrowing to fund may be a good strategy to access capital at low rates, and it could contribute to the growth side of the plan assets where higher returns can be earned.
An ability to quickly change the plan’s interest rate exposure or hedge ratio is essential for capturing funded status gains in the event that rates rise, Mercer says. This may require investing beyond cash bonds and considering investment instruments such as interest rate swaps and futures.
DB plan sponsors have to manage their fiduciary risk, regulatory risk and market risk, McCareins adds. “If plan sponsors are keeping their plans going, they have to address investment issues differently than if they are planning to terminate the plan or transfer the assets,” he says.
McCareins says he is seeing a trend toward investment outsourcing among DB plans. Plan sponsors are asking why they are allocating resources to managing the three risks when they can share the fiduciary liability with an outsourced chief investment officer (OCIO) firm. In addition, many are losing their retirement plan expertise—pension managers that have been with companies for years are retiring—and resource constraints lead them to elect to outsource investment management rather than retool staff.
Over the past several years, many DB plan sponsors have moved to liability driven investing (LDI) strategies, including a de-risking glide path in which investments change as plans achieve certain funded status triggers. Fischer believes in 2015 plan sponsors will ask whether they should abandon their LDI strategy if they believe interest rates will go up, or, for those that have not adopted an LDI strategy, whether they should adopt one now.
With numerous changes in the pension and economic environment, Mercer says now is a good time for plan sponsors to take a fresh look at their glide paths and ensure that they continue to be effective. The recent publication of new mortality tables by the Society of Actuaries (SOA) will increase reported liabilities for most plan sponsors by anywhere from 5% to 10%, with a corresponding reduction in reported funded status, Mercer says. Sponsors should verify that the allocation and funded status points along the glide path are still consistent with the new liability and end-state targets of the plan.
Given that market volatility is likely to continue in 2015, sponsors on a de-risking glide path may need liquid assets available to effect asset-allocation changes promptly. Some plans may also be able to capitalize on volatility by using a more dynamic or market-aware de-risking program. A dynamic approach might have a de-risking plan that specifies risk or return targets as opposed to specific static asset allocations, which would allow the plan sponsor to identify the optimal portfolio as market conditions change. Using such a dynamic risk management process requires enhanced portfolio monitoring, coupled with a nimble execution and governance process.
Many sponsors looking to terminate their plans or complete a pension risk transfer move to an LDI strategy because, to purchase an annuity to cover DB liabilities, the plan must be more than 100% funded because of premium costs. McCareins believes there will be increasing adoption of LDI strategies despite what interest rates do.
Mercer says plan sponsors that intend to transfer risk to an insurer at a future date may want to invest assets to hedge against annuity price movements.
The bottom line, according to McCareins, is DB plan governance will be an increasing focus in 2015—to manage DB plan risks and improve outcomes. Plan sponsors should have an investment policy statement (IPS), and more importantly, adhere to it, he says.