Equity market risk and interest rate risk are the biggest risk factors for defined benefit (DB) plan investing today, according to Phil Kivarkis, U.S. director of Investment Policy Services at Aon Hewitt.
“DB plans are subject to mark-to-market accounting, so plan sponsors need to be liability aware,” he told attendees of the 2015 PLANSPONSOR National Conference. “Take the risks you will be rewarded for and get rid of the ones you won’t,” he suggested.
Kivarkis said plan sponsors may hedge interest rate risk with long-term fixed income vehicles, aligning assets with liabilities. It may also make sense to use return seeking assets, but they should be well-diversified and not overly exposed to any one equity market.
Liability-driven investing (LDI) is still being used by many plan sponsors, and the LDI conversations are still about interest rates, said Phyllis E. Klein, senior director of the Consulting Research Group at CAPTRUST Financial Advisors. “They are still expecting rates to go up, talking about the bets they are making on interest rates, how rising rates will affect liabilities, and what they can do with assets to handle that effect.”
Rocke D. Blair, practice leader for the Cincinnati market at White Oak Advisors, added that DB plan sponsors that freeze their plans pursue LDI to try to control the volatility of funding and contributions, and control for interest rate risk, but active plans also do this.NEXT: Using equity investments to boost funded status.
One way to boost funding is through equity investments, but Blair suggested plan sponsors use different types of equity that are not highly correlated to each other. He said plan sponsors, historically, think about using small- and large-cap and international equities, but most are highly correlated with respect to market movement, so emerging markets equities and alternative investments make sense.
Kivarkis noted that the Highway and Transportation Funding Act of 2014 (HATFA) effectively pushed out DB plan funding requirements three years, so that gives the market more time to do some of the heavy lifting for plans. But, plan sponsors need to manage their expectations. “I think returns will be moderate, and interest rates will move up, but slowly,” he said. “Funded status will move up, but DB sponsors will need to get out their checkbooks for the next few years.”
Smart beta is a new trend in DB plan investing, in which investors try to get better returns and a more balanced equity portfolio by focusing on factors other than market capitalization when choosing which companies in which to invest, Kivarkis noted. But, he said the next step should be an extension to alternative investments. “We think they make sense,” he said. “They enhance returns and have a low correlation to equities.”
Blair believes smart beta will replace hedge funds. But, he warned that it is just another tool in the DB investor’s toolbox and not a total solution to managing funded status.
Despite the withdrawal of DB plans from the employer-sponsored retirement plan landscape, it is still a market worth several trillions of dollars, Kivarkis noted. “If there’s a demand for a solution, someone will come up with it,” he said. “At some point there will be a move to efficient assets, and that will demand long-duration solutions.”