This case study explores navigating pension plans from static allocation to full termination. Continue reading the case study below to learn more.
A corporate plan sponsor with an approximately $1 billion pension liability wanted a strategy to terminate the pension plan within a few years.
The investment committee shared that the pension trust historically had been managed using a static allocation with 70% return-seeking assets and 30% fixed income assets. The trust was mainly frozen but had a small group of active employees continuing to accrue benefits. The manager structure was relatively streamlined, with substantial use of passive equity, low to moderate fees, and a moderate number of managers. The return-seeking assets were overweight U.S. equity compared to market weights, while the fixed income assets were intermediate duration (core fixed income and TIPS) and provided minimal liability hedging.
The company viewed its pension liabilities and expense as a distraction from its core business and wanted to reduce their impact on the balance sheet and income statement. Although the managers had performed well relative to their benchmarks, the committee recognized that an asset liability framework was needed to reduce funded status volatility and provide a path to plan termination.
In order to develop a solution, the Aon investment consulting team held an initial planning meeting with members of the client’s investment committee to analyze the current asset-liability profile and determine objective(s) for the plan. The client indicated that the primary objective was full or partial plan termination.
Shortly after the planning meeting, the Aon team presented results with de-risking elements (hedge path and glide path). Aon proposed repositioning the manager structure to improve hedging (transition to long duration fixed income), reduce fees, and reduce tracking error (switch to passive equities).
The Aon team held a follow-up meeting to review the impacts of various contribution strategies and evaluated additional options to manage/reduce pension-related costs/risks (e.g., permanent lump sum feature, small benefit annuities).
All factors were incorporated into the overall strategy, which was presented to the full investment committee. Once the strategy was determined, the investment committee reviewed governance, monitoring, and execution of the strategy. The investment committee decided to delegate operational elements of the strategy to Aon, which would allow the client to react quickly to market changes.
The investment committee worked with Aon’s investment consulting team to develop and implement a glide path, create an interest rate hedge path, transition the fixed income assets into actively managed longer duration securities, and convert the return-seeking allocation to a 100% global equity index fund. Initial changes to the trust included:
- Developing a glide path to reduce return-seeking asset targets over time with funded status improvements. The glide path used an economic liability metric to determine funded status, which incorporated costs to terminate the trust.
- Creating an interest rate hedge path that would increase the hedge ratio based on funded status improvements and/or increases in the discount rate. The committee balanced the need to reduce interest rate risk in the trust with the desire to potentially improve funded status in an expected rising interest rate environment.
- Transitioning the fixed income assets from intermediate duration products to long duration products. The new managers also implemented an overlay in order to adjust portfolio duration to match the liability duration.
Approximately one year after the initial changes were implemented, the company significantly funded the trust with the intention of terminating the plan within the next few years. However, shortly following the contribution, the company made an acquisition that brought in active participants with ongoing benefit accruals. Ultimately, the trust was split into two plans: a new spinoff “Active” plan for participants with ongoing accruals and a “Frozen” plan for participants with frozen benefits.
Subsequent changes to the trust included:
- Frozen Plan:
- Implementing 100% liability-hedging assets and a 100% interest rate hedge ratio, including more customization of the key rate durations
- Adjusting the plan allocation to account for estimated lump sum payouts
- Eliminating below investment grade holdings and non- U.S. dollar holdings in order to prepare the portfolio for the upcoming annuity placement
- Active Plan:
- Using a static allocation of 60% liability-hedging, 40% return-seeking until an asset-liability study could be performed
- Moving a portion of the liability-hedging assets from the Active to the Frozen plan, using a manager common to both plans
- Streamlining the return-seeking allocation to a passive global equity index to simplify allocation, reduce fees, and reduce tracking error
The plan sponsor is on track to terminate the Frozen Plan within the next several months.
The investment committee was pleased with the transition of the Frozen Plan from a static allocation to a dynamic glide path with low funded status volatility. The use of a glide path, coupled with contributions, positioned the plan for termination since it allowed the company to quickly adjust asset allocation to favorable market movements in 2017 and 2018.
Aon worked with the investment managers in order to reduce exposure to assets that annuity providers generally avoid, such as below investment grade bonds and non-U.S. dollars. One goal was to minimize transaction costs with the annuity placement by maximizing the amount of in-kind securities an annuity provider would take.
Additionally, the Active Plan has been streamlined with one return-seeking manager (global equity index) and one long duration fixed income manager, which has created a low-cost, low tracking error portfolio as that plan moves toward termination in the next four to six years.
The Next Steps
The project is ongoing for the plan sponsor.
The Frozen Plan will be terminated within the next several months. Aon will continue to look for ways to position the assets for favorable annuity pricing. The investment committee will review an asset-liability study on the Active Plan in the coming months to implement a glide path and hedge path.
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 in this document 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.
Aon’s Capital Market Assumption Methodology
Nominal and real government interest rates are projected using an extended two factor Black Karasinki model and a 2 factor Vasicek model respectively. The models are mean reverting starting with current yield curves and reverting towards our long-term fair values over the very long-term.
Credit spreads are modeled stochastically using a Markov based model to determine the probabilities of transition between various credit rating and default, and a stochastic parameter reflecting the level of risk aversion in the market.
Return seeking assets (including equities) are modeled using an individual asset class model with its own returns and volatilities but no correlations to other asset classes, and exposure to 6 other economic models to gain the correct correlation structures between returns for each asset class.
The capital market assumptions (CMAs) utilized in this document were developed by Aon’s Global Asset Allocation Team and represent the long-term capital market outlook (i.e., 30 years) based on data at the end of the fourth quarter of 2018. The assumptions were developed using a building block approach, reflecting observable inflation and interest rate information available in the fixed income markets as well as Consensus Economics forecasts. Our long-term assumptions for other asset classes are based on historical results, current market characteristics, and our professional judgment.
Expected returns are using AHIC Q1 2019 30 Year Capital Market Assumptions (CMAs) as of 12/31/2018. CMAs contain projections about future returns on asset classes. These do not assume additional alpha for active management strategies within these asset classes, and are modeled to represent a low nominal fee passive index, with the exception of hedge funds and private equity, where traditional passive investments are not available. Therefore, the model assumptions for hedge funds and private equity strategies include a higher model fee impact for these asset classes. You cannot invest in an asset class directly, or within the model asset classes assumed within the CMAs. CMAs do not include asset class fees or any underlying expense ratios. Expected returns are geometric (long-term compounded; rounded to the nearest decimal). Expected returns presented are models and do not represent the returns of an actual client account. Not a guarantee of future results.
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