Defined-benefit pension plan sponsors mostly worry about asset allocation in the context of expected returns, but it’s the volatility of returns, relative to the liabilities, that has been causing the real pain. Volatile investment returns, particularly those that are not significantly correlated to the discount rate of the liabilities, can cause an immense amount of funded ratio volatility, forcing a plan sponsor to make unanticipated, outsized contributions to its plan.

It’s not easy, however, to manage the volatility of funded ratios and contributions: it requires an in-depth analysis of asset allocation and the role it plays in creating risk within a plan.

A first step to managing against unexpected volatility is understanding the unique circumstances of the plan by identifying several key characteristics: current asset allocation, liability profile, funded ratio, contribution policy, status of the plan, the plan’s “end game,” and, most importantly, the plan sponsor’s risk tolerance. 

Risk tolerance can take many meanings, but in this context, we suggest risk tolerance be defined as the amount of funded ratio volatility – to the downside – that a plan sponsor is willing and able to withstand over a one-year horizon. Put simply, how much is a plan sponsor willing to let the funded ratio decline in the pursuit of higher returns? This information is critical to the development of a volatility management or liability driven investing (LDI) strategy, and a sponsor’s risk tolerance serves as the anchor to the strategy.

Using this information, a plan’s current asset allocation can be analyzed to determine if it meets or exceeds the stated risk tolerance. For example, the “typical” plan is 80% funded, invested in 60% “return-seeking” (equity and alternative) assets and 40% “liability-hedging” assets (long-duration fixed income), and is not willing to withstand a drop in its funded ratio of more than 10%.

However, using the characteristics of today’s “typical” plan, stochastic modeling of the “60/40” investment portfolio against the liabilities shows that the current asset allocation exceeds the stated risk tolerance by nearly 25%! Clearly, there is a disconnect between the “typical” plan’s goals and its actual results.

If the plan sponsor concludes that its investment portfolio is misaligned with its stated risk tolerance, the next step is to determine the optimal hedge ratio, or “LDI Score.” The LDI score seeks to quantify the asset allocation that will meet the plan’s risk tolerance. But a company can even go one step further by also factoring in plan sponsor risk and the current status of the plan. 

Plan sponsor risk is the risk the corporation is unable to meet its contribution obligations when an economic downturn causes funded ratios to decline. A plan sponsor with high risk should consider a higher hedge ratio than a plan sponsor that could easily withstand the contributions associated with a significant decline in funded ratio. The status of the plan can also figure in. For example, a plan that is frozen or closed should likely have a higher hedge ratio than a plan that is open to new entrants, as freezing or closing a plan often implies the plan sponsor is seeking to reduce the financial risks of maintaining an active plan.

The End Game
We can also use this approach to determine the optimal edge ratio for the plan’s “end game.” The end game is the ultimate goal for the pension plan (i.e. remain open, close to new employees, freeze, or fully terminate). More specifically, as the plan approaches its target funded ratio and has largely de-risked, the sponsor should have much less tolerance for risk. The plan’s end game may also include freezing or executing a buy-out of the firm’s defined benefit pension obligations, which would also call for a significantly higher hedge ratio at the end-stage.

Once the optimized hedge ratios have been determined, finance can start to construct a de-risking path to get from the starting point to the end game. This path, called a Milestone Plan, seeks to quantify the optimized hedge ratio at each funded ratio milestone given the plan sponsor’s stated risk tolerance. The Milestone Plan is irrespective of interest rates and time, because it is the funded ratio that determines the volatility target, which in turn drives the investment allocation. 

In this framework, the path is a controlled journey to de-risking. Because the sponsor has already aligned the current portfolio with the current stated risk tolerance, which put the plan “on the path,” the funded ratio will drive the hedge ratio, regardless of the level of interest rates.

Remember, controlling volatility of the funded ratio means constructing an asset portfolio that moves in tandem with liability valuations. So, a plan that is invested in long-duration fixed income will be much more highly correlated with the double-A corporate rate curve used to discount pension liabilities. And that correlation will be irrespective of which direction rates move. Conversely, most return-seeking strategies do not show any statistically significant correlation to pension discounting methodology, leaving the plan exposed to a large amount of funded ratio volatility.

Of course, very few plans are in the position to completely de-risk in the current market climate. So there is the possibility that funded ratios – already depressed due to lackluster investment returns and increased liabilities as a result of the near-zero interest rate environment – could decline further. This is possible because the typical plan’s asset allocation only hedges about 30% of the liability. In the event of a drop in the funded ratio, the Milestone Plan can allow for re-risking by providing a guide to rebalancing the portfolio to the previous volatility target. 

However, as contributions are made to the plan and economic activity picks up, resulting in a higher interest rate environment, funded ratios are likely to improve. The improvement in the funded ratio will drive an increase in the hedge ratio, decreasing the likelihood and magnitude of future declines in the funded ratio.

So, as plan sponsors begin to think about how to avoid a repeat of the mind-numbing volatility they experienced over the past several years, their first step should be a careful assessment of their tolerance for funded ratio volatility.  This sets the stage for determining the initial rebalancing, if necessary; establishing an end game; and embarking on a path to de-risking.

Kimberlee Lisella is vice president of customized strategies for Cutwater Asset Management. She develops portfolio and business solutions for pension funds, insurance companies, workers’ compensation plans, and wind-down situations.

DISCLAIMER: The opinions expressed in this column are solely those of Cutwater Asset Management. All information presented is believed to be reliable, however the accuracy, timeliness, and completeness of the content is not guaranteed and should not be relied upon as a basis for any investment decision. This column does not constitute investment advice and Cutwater Asset Management disclaims any liability for any use of the content thereof.

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