“Meager investment returns and low interest rates made 2015 a challenging year for many defined benefit plans, with funded status rising only modestly,” says Matt McDaniel, U.S. head of defined benefit risk at Mercer Retirement. “Changing regulations and market volatility have meant that sponsors who have been proactive in managing their obligations and developing their strategy have been rewarded.”
According to McDaniel, looking ahead, Mercer believes “the path to improvement will be through taking actions when opportunities present themselves, and not waiting for a slow melt up in markets and rates.”
Discussions with DB plan clients suggested by Mercer include:
Prepare for opportunities
2015 was a year of massive pension risk transfers amid daily changes in insurance pricing. Pricing volatility was caused by both market movements and firm-specific factors. As this pricing volatility is expected to continue into 2016, sponsors have potential to materially improve their outcomes if they are able to take advantage of attractive terms when they appear. To transact quickly, sponsors should consider frontloading much of the preparation work and ensure that participant data are clean.
Plan sponsors should determine if “borrowing to fund” would have economic value. The cost to maintain an underfunded pension plan has risen due to increases in the Pension Benefit Guaranty Corporation (PBGC) variable rate premium (VRP) due to the passage of the Bipartisan Budget Act of 2015. By 2019, the VRP is anticipated to be 4.4% of the unfunded liability. In today’s low interest rate environment, accelerating the funding of pension debt (along with reducing or eliminating the VRP) may increase overall economic value.
Develop a glidepath
DB plan sponsors, especially those with closed or frozen plans, should consider taking steps to coordinate their investment strategy with the plan’s liabilities. Long maturity bonds are the best liability match and lowest-risk investment for most DB plans, so there can be a natural progression of increasing a plan’s allocation to long bonds as funded status improves.
Increase growth allocations
The prevailing outlook for bond returns is below average due to low interest rates. Whether or not interest rates rise, long bonds are unlikely to earn much more than their current yield, which is quite low. Low yields and more conservative mortality assumptions are core causes of low funded status for many plans. As such, DB sponsors should consider increasing growth asset allocation to improve long-term asset growth. This action may present short-term risks because of the higher level of funded status volatility, which can present larger balance sheet swings, more material declines in funded status, and potentially higher cash funding requirements. However, with the extension of funding relief in the Bipartisan Budget Act of 2015, the impact of short-term volatility on cash funding may be muted, allowing time for investment risk to earn positive results.
Isolate interest rate risk
DB sponsors looking to reduce interest rate risk but not decrease allocations to equity and growth assets can separate a plan’s interest rate exposure from its fixed-income allocation. Using Treasury separate trading of registered interest and principal securities (STRIPS) instead of traditional bonds or employing interest rate futures, a plan can increase or maintain its effective duration without dedicating more assets to the fixed income. Sponsors have the opportunity to reduce funded status volatility by reducing interest rate risk—via increasing fixed income duration—without simultaneously transferring assets from growth investments with better prospects to low-return fixed income.
Plan for liquidity
Investing in private assets with a higher potential return, such as private equity, real estate, debt, or infrastructure is another way DB sponsors may improve asset growth in 2016. These kinds of assets can be used in a plan with an appropriate time horizon, usually at least 15 years. Sponsors considering these kinds of assets need to understand their liquidity constraints.
Design the investment end state
DB plan sponsors that have already frozen their plans should consider developing an “end-state” strategy. Whether a plan sponsor chooses to terminate the plan and transfer all payments to an insurance company and participants, or “run out” the plan, a strategy to reach the needed funding level, typically a combination of investment, contributions and liability management, should be developed.