Plan sponsors should think about their purpose and key objectives when managing investment portfolios, says a paper from Willis Towers Watson.
While the paper addresses investment considerations for both defined benefit (DB) and defined contribution (DC) plans, it says DB plan sponsors should understand what their return needs are relative to their desired objectives. “For example, we have seen some plans de-risk too quickly with a capital allocation glide path, leaving the plan with insufficient returns necessary to reach its goals,” the report says.
Sweta Vaidya, North American head of solution design at Insight Investment in New York City, says what DB plans should do in 2022 will depend on what happened to the specific plan in 2021. “Many plans have seen a funded status improvement,” she says. “Regardless of whether a plan is open, closed or frozen, any gains earned should be protected.”
Vaidya says open plans can probably continue to hold some risk because they will need growth to meet obligations that are continuing to accrue. Still, they have an incentive to take some risk off the table to protect funded status.
The funded status means something different for frozen plans than it does for open plans, says Vaidya. For example, because an open plan will continue to accrue benefits, even if it is 100% funded, it will need to hold some risk. However, fiduciaries of a frozen plan could probably decide the plan only needs a 5% buffer over full funding to protect against volatility. “It would depend on the objectives of the plan sponsor plus any constraints on cash,” she says.
Willis Towers Watson says it believes investors require an expanded return-seeking opportunity set to make portfolios more resilient in the face of an inflationary environment. “Specifically, the uncertain policy environment associated with stimulus being withdrawn, corresponding rate rises and inflation risk will require traditional portfolios of equities and investment-grade credit to be scrutinized under these scenarios,” the firm says.
For DB plans, the volatility of rates is expected to impact both liabilities and assets, “with credit and Treasury bonds expected to perform poorly due to rising inflation risk premia and secularly low-starting yields,” Willis Towers Watson says. Plan sponsors need to understand how their existing portfolios will respond to different inflation scenarios and identify new sources of income that are typically more resilient to inflation.
In 2022, Vaidya says, it will be important for DB plan sponsors to de-risk in both fixed income and equity.
“For growth assets, diversify out of equities, because we feel like they are overvalued and we expect a correction,” she says. “Plan sponsors should consider real assets, private equity, infrastructure, hedge funds or multi-asset class strategies, as well as private credit. Over the years, we’ve seen plan sponsors start to gravitate toward these.”
On the fixed-income side of the portfolio, yields are low, and credit migration risk will add a wrinkle if defaults or downgrades affect assets differently than liabilities, Vaidya says. “It’s difficult to perfectly hedge liabilities, but plan sponsors are looking into emerging market debt, structured debt, private debt, fallen angels and bank loans,” she says.
While inflation could be a good thing for corporate DB plans in the U.S. because it might decrease costs, the Federal Reserve’s reaction to it could have an effect on how DB plans should invest, says Vaidya.
“All else being equal, it’s probably not a big issue,” she says. “Corporate DB plans don’t usually offer COLAs [cost of living adjustments] for retirees, and some plans are holding real estate and infrastructure investments, which will keep assets growing. But plan sponsors are concerned that the Fed might quickly raises rates, dampening returns on fixed-income portfolios. Sponsors will need to look at their strategies for managing interest rate risk.”
Willis Towers Watson says private assets, particularly private loans with floating rate coupons, as well as real assets, which have a natural inflationary component, may become more relevant tools for plan sponsors to weather future inflationary pressures.
With a more than 5% annualized inflation rate through the end of May in the U.S. and increasing inflation fears, Morningstar Indexes studied 2021 year-to-date index returns. The results suggest that value stocks, commodities, real estate and Treasury inflation-protected securities (TIPS) can be inflation buffers.
“The past few months have presented a unique opportunity to test the performance of various asset classes in an environment of rising inflation and inflation expectations,” says Dan Lefkovitz, strategist, Morningstar Indexes, in Chicago. “Notably, value-oriented stocks have responded well to economic growth and a concurrent rise in interest rates. And ‘real assets’ such as commodities and real estate—traditional inflation hedges—have been true to form. And, on the fixed-income side, TIPS are a great hedge to inflation, as returns are tied to the U.S. Consumer Price Index [CPI].”
“Inflation has a devastatingly corrosive impact on purchasing power and the current bout of higher prices is a real-time reminder for investors to remain ever vigilant,” says Mark Carlson, senior investment strategist- FlexShares at Northern Trust Asset Management in Chicago. “Maintaining a strategic allocation to real assets such as a broad selection of natural resources, real estate and infrastructure assets has the ability to provide durable long-term inflation protection for portfolios.”
Other Investment Considerations
Willis Towers Watson says the expansion and extension of funding relief for DB plans via the American Rescue Plan Act (APRA) has provided plan sponsors with increased flexibility in pursuing their objectives, as the potential for higher contributions has been reduced. It says this could allow some plan sponsors to pursue a more aggressive investment strategy that can ignore some of the bumps in the road that might have previously triggered a cash contribution. Alternatively, plan sponsors that are looking to take on less risk might be content with a longer time horizon on their path to achieving their goal.
But, Vaidya warns, the funding relief might give plan sponsors the urge to re-risk. “I can see that happening with poorly funded plans, which could create a lower likelihood of achieving fully funded status,” she says.
Willis Towers Watson also suggests that plan sponsors consider active management and more high-conviction portfolios that can add value. “The individual manager volatility can be offset with a multi-manager structure, with monitoring relative to objectives and/or a benchmark occurring at the aggregate or total structure level,” it says.
More specifically, Willis Towers Watson says DB plan sponsors should consider extending their high-conviction investment strategies into potential return-generative ideas—for example, credit and real assets—other than equities. And the consultant warns plan sponsors not to “lend where it’s crowded. Instead, evaluate where you lend and aim to reduce corporate lending risk, given overlap with your equity portfolio.”
In addition, Willis Towers Watson suggests that DB plan sponsors consider integrating investment themes into portfolios, such as environmental, social and governance (ESG) investing. “An area of focus that investors will likely need to embed within their programs is management of climate risk and its potential impact on asset returns,” the report says. “Having a more explicit focus on climate risk throughout your portfolio could lead to alpha opportunities and/or more sustainable cash flows.”
On a similar note, the consultant says diversity, equity and inclusion (DE&I) has never been more top-of-mind for the asset management industry. According to the paper, DE&I evaluation “requires a holistic assessment that goes beyond simply looking at ownership. We believe that ownership is an easily attainable metric that fails to integrate diversity across different functions within an organization. We believe that the only way to have more diverse-owned investment firms is to first have diverse investment leaders and teams. By measuring diversity across these three levels, we believe the resulting evaluation helps provide a more robust and relevant picture of diversity.”
Willis Towers Watson says its beliefs are backed by its research, which shows that investment teams that are more diverse result in greater investment returns.
On a final note, Vaidya says there’s a risk of plan sponsors being unprepared. For some, the funded status improvement came quickly and they adjusted their glide paths, but others don’t have glide paths in place. “Teams in general should ask what their goals are and whether they are prepared as they get closer to their goals to take action and make changes to their portfolios,” she says.
The full list of issues Willis Towers Watson says retirement plan sponsors need to consider in 2022 is in its paper, “Investing With Purpose in 2022.”
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