This is the fourth article in a series that has revisited the design of hybrid pension plans—plans that deliver the better of a defined benefit(DB)promise and a defined contribution(DC)account balance. This article will focus on the question of investment policy from the perspective of the plan sponsor. A future article will address the combined issues of employee investment choice and employee communications.

The specific design that this series has addressed is the following:

• DC component: 5% of earnings contributed by both the employer and the employee for a total contribution of 10%
• DB component: 0.8% of final three-year average earnings for each year of employment, with no inflation protection

This design was intended primarily to deliver a DC benefit and to have the DB component act as a “safety net.” The most recent article in this series demonstrated that the intention of the design was actually being carried out in practice. That is, only in the event of severe adverse economic conditions would the DB component affect the benefit being delivered from the plan.

The implication of this is that, from an investment point of view, the sponsor should consider the plan as a DC plan and establish an investment approach as if it were a pure DC plan: provide an appropriate default option; select “autopilot” options, such as target date funds; and potentially provide greater investment selection for those plan participants that may be interested. These issues, and others, will be explored more fully in the next article in this series.

On the other hand, what if the design is such that there is a reasonable expectation that the plan will deliver the DB component, rather than the DC component? The sponsor is now exposed to the uncertainty of funding the benefit, and should think of the investment policy in a similar vein to a pure DB plan. In this environment, there is a good argument not to provide plan participants with any investment choice. The sponsor first needs to consider the amount of financial risk that is appropriate in order to optimize the following objectives:

• Maintain expected costs(either cash contributions or pension expense, as appropriate)at reasonable levels;
• Ensure that the variability in costs is manageable; and
• Provide for the security of plan participants’ benefits.

Establishing the appropriate degree of financial risk is fundamental to developing investment policy and is unique for each plan. At a high level, it determines the proportion of bonds of any type relative to other asset categories, and it also determines the structure of the bond investments. Conceptually, this way of thinking is referred to as liability driven investment(LDI), where the bond investments are structured to provide the appropriate degree of matching with the liabilities. The answer to the question of what is the appropriate degree of matching is also unique for each situation. Unfortunately, LDI is often sold as a product rather than a concept, on the basis that a generic solution can be found.

While many plans have, in fact, increased the interest sensitivity of their bonds in order to provide a better match to the liabilities, in the current environment of better- funded plans, the more important course of action may well be to reduce the allocation to equities. This would reduce the benefit security risk for plan participants and create a better risk/reward trade-off for plan sponsors—sponsors who know they own 100 cents of every dollar of deficit, but may not be entitled to 100 cents of every dollar of surplus.

The key message is that there is an appropriate investment decision that needs to be tailored for each pension plan, regardless of its design. As pension plans have matured and many have become quite large relative to the size of their sponsors, generic solutions are no longer sufficient.

If you’d like to comment on this story, click here.

For more about our Online Expert Panel, click here.