Your DB Funded Status Has Improved? Now What?

Corporate DB plans have experience funded status improvement, and LDI strategies help plan sponsors preserve this; however, investment committees are looking for new asset classes that can provide greater returns at a reasonable level of risk.

Northern Trust Asset Management (NTAM) believes it is critical for corporate defined benefit (DB) plan sponsors to understand the impact the DB plan has on overall corporate financials, and it ties this in to pension investment strategy in an new report, “Corporate Pensions: The Bottom Line.”

According to the report, during 2017, corporate DB plans experienced their greatest improvement in funded status in the last five years—improving from 81% to 85%—the largest one-year increase since 2012 to 2013. While the equity markets were a significant contributor to that growth, another significant contributor came from corporate cash contributions.

During 2017, corporations in the S&P 500 contributed $77 billion in cash to their DB plans. NTAM says that is a material capital allocation to what is essentially a debt obligation for many plan sponsors and a tie-up of capital that cannot be used for corporate growth or distributed to shareholders. However, a key benefit to these large contribution is the effect on corporations’ income statement—the pension expense recorded on corporate income statements has fallen to its lowest levels since the financial crisis. In 2017, the average pension expense was just 3.4% of total operating income—a significant drop from 5.2% in the prior year.

As corporations are allocating more capital to their DB plans, they are better able to manage their pension costs and improve the funded health of their plans. And, they are looking hard at their investment strategy to try to preserve improved funding and seeking ways to reduce the outstanding deficit of their plans.

NTAM says the trend toward liability-driven investing (LDI) has continued. Ten years ago, the average fixed income allocation for S&P 500 DB plans was 31%. In 2017, it was 43%—a 2% rise from the prior year. Equities, which were at 60% ten years ago, have fallen to 37% in 2017. With LDI, the investment strategy changes as funded status improves, but NTAM finds there is often a one-year lag, as it likely takes some time for investment committees to enact changes to their asset allocation strategy. For example, in 2010, the funded status improved from 81% to 83%, but it took until the following year for fixed income allocations to increase from 36% to 40%.

However, with plans that use automated de-risking glidepaths, the allocation change happens sooner. In 2017, funded status improved from 81% to 85%, and in the same time period, fixed income allocations increased from 41% to 43%.

Moving from equities to fixed income allows DB plan sponsors to preserve the funded status they have achieved due to market returns and capital allocations, but investment committees are looking for new asset classes that can provide greater returns at a reasonable level of risk.

NTAM says it believes DB plan sponsors should get compensated for the risks they take, and offers four considerations for setting DB plan investment strategy:

  • Understand the true risks in the portfolio. Scrutinizing the asset allocation through the lens of the underlying risk factors often reveals unintended or oversized exposures. By understanding the portfolio’s exposure to certain market dynamics like inflation, economic growth, currency or other macro factors, plan sponsors can ensure their capital is deployed in line with a rational market view.
  • Focus on intended and compensated plays. Even a passively implemented portfolio will have bets, be that high degrees of concentration to particular sectors or securities or a bias toward momentum. Once a plan sponsors understands its bets, it wants to position its DB plan portfolio towards those bets it believes will be compensated and in line with a long-term strategy.
  • Choose liability hedging instruments wisely. Choosing the right strategy and adjusting that strategy is critical to managing pension risk, NTAM says. Use of an active manager to manage long credit exposure can reduce the downside risk associated with material credit events that cannot be achieved through a passive index investment. However, a passive investment for long government allocations could be a more cost-effective instrument—it can provide very low cost duration and an effective tail-risk hedge to the portfolio. As a plan becomes better funded, the plan sponsor may want to consider increasing the precision of the hedge through overlay or completion strategies.
  • Be dynamic and nimble. Markets are dynamic and they will change, and NTAM says successful institutional investors need to do the same. With a strong understanding of a long-term goal coupled with an appreciation of the underlying risks and drivers of a portfolio, a plan sponsors is better positioned to be dynamic when markets provide opportunities. NTAM says this may come in the form of an active rebalancing policy which allows plan sponsors to buy on the dips and sell into strength, or it could take the form of a de-risking glidepath which allows for buying into bond weakness as rates go up. NTAM says derivatives can also be effective tools to help manage a flexible strategy.

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