Over the past few years, many plan sponsors have sought to de-risk their DB pension plans. This has manifested itself in different ways—from simply diversifying the return-seeking portfolio to purchasing more matching bonds in order to stabilize contributions and better match liabilities. The latter activity has often involved developing a journey plan—a pre-set range of actions or glide path that the plan sponsor will take when something happens. Usually, the triggers are related to an interest rate level, a funded ratio or a combination of both.
After implementing these journey plans, many plan sponsors have seen their funded ratios improve. However, the source of the improvement has not always been what the sponsor had expected when entering into the journey plan discussion. The addition of fixed income as funding improves was intended to reduce risk (i.e., take your winnings off the table).
There was an expectation that the purchase of additional fixed income would result, at least partially, from rising interest rates and an ensuing decline in liabilities. Instead, what many have seen is a spike in the funded ratio due to contributions and strong returns from the return-seeking portfolio.
Many plan sponsors are now grappling with how to deal with the next steps suggested by their journey plans—purchasing more bonds at a time when fixed income yields remain very low by historical standards and where the future return prospects for these assets is poor. Some plan sponsors are dealing with this disconnect by suspending their journey plans and/or resetting their triggers. The end result of this is that de-risking will take place over a longer period of time than originally anticipated.
One option that has been adopted by many plan sponsors is to take steps to re-risk the return seeking portfolio by moving a portion of the assets to something (other than bonds) that is not correlated with the public equities.
However, there is another way to think about this. The source of the funded ratio improvement does matter. Perhaps the time has come to consider more dynamic approaches to asset allocation.
Historically, glide paths have been set to move X% of the investment portfolio from return-seeking assets to fixed income when triggers have been met. For simplicity, we’ll use 10% as the desired movement. Under this scenario, the sponsor would sell 10% equities and purchase 10% bonds when a threshold is triggered.
A revised approach would change the action taken depending on the reason for the trigger being achieved. For example, if interest rates increase, the action may still be able to sell 10% equities and purchase 10% bonds. This makes sense since the plan is benefiting from reducing risk at a time when liabilities are also declining. However, if the funded ratio improvement occurs because of contributions or strong investment returns from the public equity portfolio, under this revised approach, the plan sponsor may wish to only de-risk by 5% to avoid purchasing an excessive amount of low-yielding bonds. While this is a more complex approach than the simple 10% movement, there is a certain logic associated with it.
A more dynamic approach may not be suitable for all. Each plan sponsor needs to determine its risk tolerance and timing when considering the de-risking question. However, it’s always healthy to revisit beliefs and strategies periodically. The continuation of low interest rates, despite recent increases in bond yields, suggests now may be a good time for these discussions.