Willis Towers Watson (WTW) has outlined 10 action items for defined benefit (DB) plan sponsors to consider when planning for the next year and beyond.
First, there are tools DB plan sponsors can use to develop strategies to manage market surprises such as the global financial crisis of 2008 and 2009. According to Chris McGoldrick, head of defined benefit delegated investment solutions at Willis Towers Watson in Philadelphia, these tools include stochastic forecasting, risk-based analysis and also understanding the nuances of the plan’s liability and how that will shift and change based on capital market conditions. “We couple that with broader portfolio testing and analytics—more than risk and return metrics—such as the potential impact on capital funding or the speed at which a plan can reach termination status,” he tells PLANSPONSOR.
WTW points out that not all asset classes, managers and strategies struggled during the global financial crisis. Some investment strategies—reinsurance, merger arbitrage and momentum—came out of the period ahead. Going forward, it’s unlikely that everything will implode at the same time, so diversity is key.
With the shift toward closed, frozen and terminated plans with the potential transfer of risk to insurers, many portfolios have loaded up on long credit bonds, reducing their return potential, according to WTW. The firm says there is a delicate balance between building a powerful return generator and managing your liabilities, and through capital efficiency and diversification, it says the appropriate balance can be achieved.
Explaining capital efficiency, McGoldrick says DB plans generally have a funding gap, and they realize they have to fill that gap with either cash or portfolio returns. They would rather use cash for other business needs. Capital efficiency includes hedging liabilities using the least amount of assets, which is cost efficient, McGoldrick says. “DB plan sponsors can build a hedging portfolio with less assets and using instruments beyond bonds, such as Treasury Separate Trading of Registered Interest and Principal of Securities (STRIPS) and other leveragable interest-rate derivative instruments,” he explains.
WTW also suggests DB plan sponsors concentrate their equity bets. The firm partnered with a number of equity managers to build high-concentration mandates and was very pleased with the results.
According to McGoldrick, a typical asset manager offers 70 to 100 stocks, and WTW asked managers for their best 10 to 20 ideas—from where they get all alpha performance. Combining these from a diversification standpoint offers a higher return with lower volatility. “We’re seeing alpha performance relative to equity benchmark with half the volatility that usually see,” he says. He adds that when taking the top 10 from an asset manager with 70 stocks, the other 60 are usually designed just to mitigate risk.
WTW also suggests DB plan sponsors be a bond market trendsetter. “If your governance structure allows, we believe there are large opportunity sets in securitized credit, banks loans and private debt. Even for the less adventurous investor, it’s worth exploring ways you can use the expanded bond universe to overcome the dwindling long credit supply or to build an attractive growth complement to equities,” the firm says.
In addition, the firm suggests DB plan sponsors revisit their financial management strategies. Sponsors may be seeing their highest plan funded status since the global financial crisis WTW points out. “If you saw your funded status nosedive a decade ago, you have a second chance at locking in your improved position. Revisit your company’s funding and accounting policies, the plan’s strategic asset allocation, and progress along your de-risking glidepath and long-term forecasts of plan financials to confirm the path you’re on is the right one for you,” the firm says.
Regarding potential annuity purchases to transfer DB plan risk, WTW says that when a plan sponsor’s investment consultant and actuary partner together, they can better define the appropriate transaction size, manage the required liquidity and identify potential asset-in-kind transfer opportunities.
McGoldrick explains that there could be a better way from a capital efficiency perspective to go out to the annuity market. For example, if a plan sponsors is trying to offload $1 billion in plan liabilities, does it make sense to go to one or more annuity providers, does it make sense to divide by individual so one provider pays half of a participant’s benefit while another pays the other half, does it make sense to transfer cash (liquidating portfolio) or do an in-kind transfer of the part they’re liquidating? He says an insurance company may want the bonds in the plan’s portfolio it may have intended to buy itself. “Getting rid of the buying and selling cycle can bring down the cost of a risk transfer transaction,” McGoldrick
He adds that DB plan sponsors need to also start to look at buying annuities for someone who has deferred his DB benefit payment, and look at the most cost-efficient way to purchase that annuity.
All types of plan sponsors are increasingly focused on reducing investment fees, WTW emphasizes the value for fees, not the fees themselves. Many of the strategies mentioned earlier might result in higher headline fees, but if they lead to significantly lower contributions for DB plan sponsors, the value-add might just be worth the higher fee.
WTW also suggests DB plan sponsors consider their governance structure. DB plan sponsors may be faced with too many investment decisions with insufficient time to vet them. The firm says DB plan sponsors are continuing to find that delegation can potentially lead to better financial outcomes, better execution and better value and also help to provide an additional layer to fiduciary documentation and oversight that is critical to supporting fiduciary decisions.
Finally, the firm suggests DB plan sponsors maintain their DB plan if it’s the right fit. McGoldrick explains that there are many things to consider in determining whether to maintain a DB plan. For example, the plan sponsors may be paternalistic in nature. The participant base may have difficulty saving on their own and the plan sponsor believes it may be important to do that for them. The plan sponsor may determine that the DB plan will be able to target more replacement income for participants.
In addition, according to McGoldrick, the DB plan sponsor may be worried about the generational transition of its workforce and having a DB plan can incent older generations to move on. A DB plan provides annuity type options for distributions which can help participants plan better for retirement income.In some cases, according to McGoldrick, running a DB plan could cost less for the plan sponsor than a similar target retirement benefit in a defined contribution (DC) plan because of the return generating power of portfolio aggregation.