Sponsors of defined benefit pension plans have seen significant volatility in the value of their assets, liabilities and funded status through the course of 2022. On balance, the funding deficit of most plans has reduced as the present value of liabilities has decreased faster than asset values. This is due to sharply higher long-term interest rates, which has produced a surprising win for DB plan sponsors despite the difficulties in the markets.
However, as seen in the example above, the funding level in percentage terms for many plans has not materially improved which can lead to unintended risks being taken going forward.
These unintended risks are a result of the use of automatic glidepaths as part of the strategic asset allocation policy. These glidepaths are typically built upon changing the asset allocation as the funded percentage changes but ignores the dollar amount of unfunded liability. As a result, many plans may not have changed their asset allocation to help reduce future risk as a result of the improved funded status.
Plan fiduciaries using glidepaths with triggers based on funding level percentage should consider whether they should override these triggers given the improvements many plans have seen to-date.
With the current economic environment and changes to funded status, this is also a perfect time for plan sponsors to re-evaluate their glidepath as there has been improvements in glidepath construction over the years.
For example, glidepaths have evolved to allow a plan sponsor to be able to select which risks to manage and to what extent. Traditionally a glidepath would balance the risks between equity markets (i.e. return seeking assets) and long credit rates (i.e. liability matching assets). Modern glidepaths allow a plan sponsor to maintain a certain expected return while reducing risk over time. These decisions regarding expected return and risk can help improve the funded status going forward.
Let’s use the above example to show this.
A typical glidepath may not change the asset allocation for a change in funded status from 83% to 85% despite the dollar deficit declining by over 33%. Thus, if rates were to decline, and even if markets were to recover, one may find that their funded status remains in the 85% range, but that the deficit returns to a higher level on a dollar basis.
A sponsor could change their glidepath and increase their LDI or hedging portfolio. This will help protect the funded status dollar amount, but will lower the expected return of the portfolio, which means the sponsor will either increase the expected time to plan termination or increase the need for cash contributions in the future.
A more modern glidepath would use a relatively modest amount of leverage to allow the plan sponsor to keep their equity exposure but shift more physical assets to the hedging/fixed income portfolio. This can be done through futures or equity derivatives. If simple equity puts and calls are used, a sponsor could further reduce risks via the application of the puts and calls and limit some of their downside equity risk.
In summary, large market movements like we have seen in 2022 create a perfect opportunity for plan fiduciaries to re-visit their asset allocation and de-risking strategies. There is no “one-size-fits-all” approach to pension plan investment and, in particular, to how a plan should reduce risk over time.
