Conceptually, the traditional glide path approach to de-risking may make sense because it provides a disciplined framework for reducing risk, and as a result decreases the likelihood that plan sponsors will be confronted with unanticipated funding obligations during adverse market conditions. But the current environment of low interest rates could actually make this risk-reduction approach riskier, according to a paper from Cambridge Associates, “Pension De-Risking in a Low-Rate Environment.”
"In normal markets, shifting funds out of growth assets into liability matching, or fixed-income assets, will reduce funding risk but also reduce expected returns and thus increase projected contributions,” said David Druley, managing director and head of the global pension practice at Cambridge Associates. But Druley cautioned that in the current environment of fixed-income overvaluation and historically low interest rates, a traditional glide path can result in a significant decline in expected returns and increase the likelihood that the plan sponsor will need to make higher contributions.
The traditional glide path neglects the objective of maximizing return at each targeted level of risk, he said. It typically uses just one lever to reduce risk—the fixed-income allocation—which may not generate enough return in today’s environment.
“If increasing long-duration bonds and liability hedging assets is the sole lever being pulled to reduce a plan’s liability relative risk—which many simple glide paths embrace—then the plan is uniquely vulnerable to the overvaluation of bonds and therefore bears the full cost of locking in the lower expected return of liability hedging instruments,” Druley told PLANSPONSOR. “Additionally, with interest rates near generational lows, the liability relative risk resulting from changes in rates is highly asymmetric, with the potential for only modest increases in the liability in a worst-case scenario of the U.S. ‘becoming Japan’ (i.e., rates declining).”