Many DB pension plan sponsors in Canada are revising their investment strategies to focus more on risk management in order to better manage funded status, contributions and financial statement volatility. The key question is, How should plan sponsors determine when and how to change their strategy?
An increased focus on risk management generally requires higher allocations to liability-hedging assets (bonds). But making a significant shift to bonds now may be undesirable, locking in a low funded status at a time when interest rates (having declined significantly over recent years) may have more potential to increase than to decrease if economic conditions improve.
In conjunction with a shift from return-seeking assets (equities) to liability-hedging assets, a greater focus on risk management often also results in a desire to better match the characteristics (e.g., duration) of the bond portfolio with the characteristics of the liabilities using liability driven investing (LDI) strategies.
Sponsors can efficiently achieve their long-term risk/reward objectives by using proactive de-risking investment policies that focus on dynamic asset allocation and result in gradual reductions to investment risk as the plan’s funded status improves through asset returns, interest rate increases and/or contributions.
The dynamic asset allocation process
These strategies for DB plans generally use funded status as the basis to increase the target allocation to bonds. A common approach is to increase the bond allocation using predetermined triggers based on the funded ratio (see chart below).
These are not market-timing strategies; rather, they are tactics to achieve the plan sponsor’s desired long-term financial risk reduction objectives. There is no magic answer as to the speed of de-risking and the number of triggers, but a key goal is to attempt to increase the liability-hedging allocation and gain a greater focus on LDI after strong equity returns and/or increases in interest rates, when the changes are less likely to have a materially harmful effect on costs. Plan sponsors must balance the desire to earn their way to full funding with their ability to accept risk.
There are three primary factors to consider when designing de-risking investment policies: the initial policy allocation, the ultimate policy allocation and the “glide path” moving from the initial to the ultimate allocation (i.e., an allocation that moves from more aggressive assets, such as equities, to more conservative ones, such as bonds).
While the appropriate dynamic asset allocation strategy is unique to each plan sponsor, there are common factors that influence sponsor approaches, including the following:
- current funded status;
- plan status (ongoing, closed or frozen);
- size of the plan relative to the size of the organization;
- plan design and maturity;
- acceptable level and potential volatility of contributions and pension expense;
- capital market views; and
- desire to eventually transfer risk (i.e., to annuitize).
Plan sponsors should use a comprehensive process to design customized dynamic asset allocation strategies specific to their circumstances and objectives.
Implementing the investment policy
In designing such a strategy, it is important to align the pension committee’s governance structure with the de-risking investment policy.
In many cases, plan sponsors will need to refine their governance structure to ensure efficient implementation. Some sponsors may treat the de-risking policy as simply more of a mindset; however, formally incorporating the dynamic asset allocation strategy into the investment policy statement or having a separate stand-alone document ensures that the strategy will be implemented as intended.
Given the potential for significant changes in funded status over short time horizons, pre-approval should be granted, and authority to execute the dynamic asset allocation should be delegated to committee members or staff. Pre-approval will remove the emotional aspect of the decision-making process. This is important because dynamic strategies may require plan sponsors to take counter-cyclical action (i.e., selling stocks as markets are rising). Pre-approval should also result in more timely execution and avoid time-consuming debate that may ultimately result in a missed de-risking opportunity.
Plan sponsors will need to consider a number of issues as they develop and implement a de-risking investment policy. Following are six questions that plan sponsors need to think about.
1. Is now the time to begin a de-risking investment policy?
Currently, interest rates are low relative to historical levels. However, there are factors that could keep interest rates relatively low for some time or perhaps even cause them to decrease further. Implementing a de-risking policy doesn’t mean that immediate action is required; rather, the policy can be viewed as a blueprint to ensure that future action is taken when it’s prudent to do so.
2. How often is the funded status monitored?
Plan sponsors need to evaluate the costs and benefits of more frequent versus less frequent monitoring. As more plan sponsors implement dynamic asset allocation strategies, there could be a real benefit to gaining a first-mover advantage (i.e., if all pension plans are trying to buy bonds at the same time, the potential opportunities may become harder to capitalize on).
Quarterly monitoring aligns closely with the current governance processes of most plan sponsors. However, monthly or even more frequent monitoring (perhaps as the funded status approaches the next trigger point) may be appropriate for some plan sponsors.
3. Is the dynamic asset allocation strategy strictly a de-risking policy, or is re-risking also appropriate?
Generally, dynamic asset allocation is viewed as a de-risking strategy and is operated on a “one-way street” basis. That is, each time the plan’s funded status crosses the next trigger point, a new target asset allocation is established (based on the glide path), but no change occurs if the funded status then declines below the trigger point.
Some plan sponsors have implemented two-way strategies and will re-risk the allocation if the funded status declines, in an attempt to better manage the affordability versus variability of cost conundrum.
4. How should the portfolio be rebalanced?
Rebalancing ranges should be wide enough to allow efficient rebalancing by minimizing transaction costs. Thoughtful flows and monetizing investments to fund benefit payments will reduce the transition costs. For example, sourcing benefit payments from equities and making future contributions to bonds may be well aligned with the dynamic asset allocation glide path.
5. What role exists for active equity managers?
Plan sponsors should reevaluate the costs and benefits of active management. Depending on investment beliefs (e.g., those with a shorter time horizon or smaller ultimate equity allocation), the potential benefits of active management may diminish to the point where it may be appropriate to focus limited governance resources on monitoring and executing the dynamic asset allocation strategy rather than on evaluating active managers.
At a minimum, plan sponsors that continue to use active management may want to reduce the number of active managers as the dollars allocated to equities decrease, as lower average mandate sizes will increase the total fees paid to managers as a percentage of assets.
6. What mandates should bond managers have?
Many DB plans have moved to long bonds in order to better align assets and liabilities. If the liability duration is significantly different than that of long bonds and/or as the allocation to bonds increases, it becomes more important to provide liability cash flows to the managers and develop tailored benchmarks.
However, significant refinements to the bond portfolio may not be warranted while a large equity allocation remains. Where the governance budget allows, active bond managers with strong credit research capabilities (to anticipate upgrades, downgrades or defaults) may provide opportunities to enhance returns.
Active management can also be used when working with plan-specific cash flows in LDI mandates. Plan sponsors that use active management should consider the benefits of using a multi-manager structure to limit manager-specific risk and improve portfolio diversification.
For DB pension plan sponsors that want to change their investment strategies to focus more on risk management, dynamic asset allocation strategies can allow them to efficiently achieve their long-term risk/reward objectives, while maintaining some upside relative to a one-time significant shift in asset allocation today. But while there are many themes common to plan sponsors considering de-risking investment policies, each strategy should be tailored to the sponsor’s unique characteristics and goals.
Richard Brown is an investment consultant with Towers Watson. richard.brown@towerswatson.com
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