Improving Expected Returns: Corporate Defined Benefit Plans 

Many Plans have seen the expected return on assets relative to liabilities fall due to i) a significant increase in long term interest rates and 2) continued de-risking from equities into bonds.  This can have a negative impact on reported earnings.  A lower expected return is also likely to increase the amount of cash contributions ultimately required to terminate the plan.

Many corporate defined benefit pension plans utilize interest rate derivatives and/or long dated US Treasuries to manage interest rate risk that arises from a mismatch between their assets and liabilities. They also typically have large allocations to active fixed income managers as part of their liability-matching bond portfolios.  The remaining assets in the Plan are typically invested in return seeking assets such as equities, with the goal of outperforming the liabilities.

Plans that invest in the above manner could improve returns, without taking additional risk to funding, by making some changes. Specifically, plan sponsors should consider:

  • Selling some or all equity allocations and investing the proceeds in actively managed long duration fixed income (a mix of credit and Treasury) designed to match plan liabilities;
  • Entering into equity derivative contracts that replicate the equity exposure that has been sold;
  • Reduce the amount of interest rate derivatives or long dated US Treasuries used to account for the additional long duration assets now held.

The net impact of the above is to replace equities with long duration fixed income + equity derivatives. By allocating in this way, the plan can expect a net improvement in expected return of 1.0% – 1.25% per annum on the exposure replaced, or $10-12m per year of additional gains from a $1bn allocation.

In summary, Plan sponsors who are implementing a de-risking process should consider this allocation strategy as it can be significantly more efficient than using interest rate derivatives to manage duration.  It also makes it easier to maintain equity market exposure while allocating more to liability matching bonds, to maintain or even increase expected returns through the de-risking process.


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