For defined benefits plans, we strive to balance risk based on each plan’s unique asset/liability characteristics, whether the plan is open and ongoing or frozen and on a path to termination. The following is representative of a typical holistic strategy we may implement to de-risk a plan. Of course, each situation is unique.
For more information information on a holistic process for de-risking a US corporate pension plan, continue reading the article below.
The key challenges we often see with corporate defined benefit plans may include:
- Management of a pension plan with a funding deficit (many had funded ratios in the low 70%1 range several years ago, though it is more common now to see them in the 80%-100% range).
- Volatile financials and funding requirements that created difficulties in budgeting.
- An allocation with a relatively high level of interest rate and market risk that was not reflective of the company’s stated risk tolerance.
- A high value placed on dynamic investment strategies by the plan sponsor, though often with limited capabilities to implement them or monitor their associated risks and triggers.
Plan sponsors often want to address these issues holistically. The following are common actions we help plan sponsors undertake:
- Design, implement and monitor a customized glide path strategy based on the plan’s risk tolerance and hurdle rate (i.e., the return on assets required to cover the growth in liabilities). This type of glide path is a dynamic approach to balancing equity and interest rate risks at different funded positions. Plan sponsors sometimes monitor their glide paths in-house, and other times they engage Aon to implement and monitor the glide path as OCIO. By way of stochastic asset-liability modeling (ALM) Aon often analyzes the potential outcomes for required cash contributions, accounting expense and funded position over the following 10 years. The recommended glide path is typically designed to:
- Provide cost savings by lowering expected future contributions.
- Provide downside protection by reducing the impact of potential unfavorable events on funding requirements.
- Reduce funded ratio volatility, which also lowers expected variability in accounting expense.
When implementing glide paths, plans typically go through many small de-risking moves as they hit progressive funded ratio triggers. Daily monitoring and the ability to trade toward new targets in a timely manner can enable the maximization of the benefits of the glide path strategy. Funded status improvements are driven by cash contributions, market returns and sometimes plan amendments such as freezing future accruals.
- We also help many plan sponsors design a customized hedge path strategy. A customized hedge path works in tandem with the glide path as an additional lever to manage interest rate risk. In this type of strategy, portfolio duration is dynamic, with de-risking triggers based on market interest rate level and funded position. It calls for a higher hedge ratio (longer duration bonds) when interest rates are high, which allows the plan to “buy low and sell high” (i.e., rotation from shorter to longer duration bonds when interest rates are high to lengthen duration when longer duration bonds are cheaper).
The strategy also determines the optimal blend of government and credit bonds to help further improve outcomes based on credit spread levels.
- Further, Aon helps revise the portfolio structure as the plans begin to de-risk according to the designed glide path. Diversifying asset classes are often used as another way to reduce equity risk2. For some plan sponsors, we also consider introducing an overlay manager to assist in duration position. This allows the plan to maintain the desired duration at all times without incurring the transaction costs of trading physical bonds. Additionally, the overlay manager is used to help avoid out-of-market exposure while awaiting the deployment of cash contributions or the settlement of trades.
- Aon also works closely with the plan actuary to help ensure liabilities are aligned with investment objectives. Refinements to the glide path liability measure should reflect the plan’s unique circumstances. The specific liability to use for monitoring the glide path may be the accounting or funding liability. However, in an increasing number of situations, we recommend using an economic liability approach which includes anticipated future benefit improvements, conservative mortality assumptions and plan administrative expenses. Using the economic liability reduces the gains or losses resulting from annual census and mortality assumption updates, which helps protect the plan from unwarranted de-risking based on short-term, non-market-related changes — thus aligning with an objective to reduce volatility.
- Additional proactive steps are often taken to undergo settlement activity. This can include reducing market exposure in a timely manner if there is a terminated vested lump-sum window offering. The lump-sum rates are known in advance, so they carry no interest rate risk. A portion of cash can be raised in advance to limit market risk, with the remainder invested in lower-risk assets. Hedge funds and shorter-duration bonds can be used to mitigate impact on yield.
The results will vary by plan. In most situations, plan sponsors have long-term objectives of fully funding their pension plan with reduced funded status volatility. Regulatory contribution requirements typically drive most plan sponsors toward the goal of full funding, and market returns and plan design changes can also influence the timing. The types of de-risking processes described in this piece can help the plan sponsor transition to a lower risk position as those funded ratio improvements occur. At their end state, it is common for plan sponsors to want the return-seeking portfolio to provide a very modest level of additional returns over the discount rate to cover plan expenses and a premium for plan termination. The liability-hedging portfolio is structured to fully hedge against interest rate risk and is expected to exhibit low tracking error.
These de-risking processes can help the plan sponsor transition to a lower risk position as those funded ratio improvements occur.
Please note: There is no guarantee that results or savings will be achieved if you should select AHIC and/or its affiliated entities to provide services to you. The experience described does not represent all recommendations made to clients nor does it represent the experience of all clients. The reader should not assume that an investment in any securities identified or a particular recommendation was or will be profitable or favorable.
1 Liability measured on a mark-to-market going-concern basis
2 Diversification does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.
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