Rising Funded Status Raises Allocation Questions

January 23, 2014 (PLANSPONSOR.com) - “What is our endgame for our pension plan in 2014?” This question is being asked more frequently as the funded status of corporate pension plans improves, Russell Investments says.

Russell’s analysis in a recent paper shows an improvement of nearly 15% for a representative open plan, and 8% for a representative frozen plan. This is indeed good news, the investment manager says, and also a big change, which will likely spark some substantial changes to the asset-allocation policies of a number of plans.

Have a clearly articulated answer to the question of what the target is, advises Martin Jaugietis, managing director of liability-driven investing (LDI) solutions at Russell Investments.

A good strategy means considering several factors. First, a firm should decide what funded level it would like the plan to achieve. “Some clients want to reduce the size of the liability,” Jaugietis tells PLANSPONSOR. This can be done by selling a portion of the liability to an insurance company. But this in turn results in the need to pay a premium. A firm might want the plan to be fully funded at 100%, or even above. Having 110% or 115% of assets relative to the liability is a possible endgame target, Jaugietis notes.

Having a fully funded pension plan could be the target, in which case plan sponsors should recognize that they do not need to take any risk relative to their liability, Jaugietis says. When a plan has a more stable funded status, the risk of large drawdowns and required contributions is minimized, and the financial risk of the pension plan itself on the company is minimized.

Plan sponsors should know an improved funded status suggests less risk is required in the portfolio, Jaugietis says. The portfolio should move in the same direction as the liability. Equity market performance or the direction of interest rates are no longer such key concerns, he adds. “If you’re fully funded you should care less about tactical views. This is a discussion to take up with the investment committee.”

Risk Reduction

The asset allocation will automatically need to change on the heels of an improvement in funded status because of liability-responsive asset allocation. This trend in pension plans, which has been in use for the past few years, involves the systematic reduction of investment risk as funded status improves. Assets are moved away from return-seeking assets and placed into liability-hedging assets, Jaugietis explains. The industry calls this an liability-driven investing (LDI) portfolio. “The rationale is essentially that the cost-benefit tradeoff changes when plans are fully funded,” he says. “Further upside is less rewarding for a fully funded plan than for an underfunded one.”

An asset-allocation glide path should be set in order to hit the target, Jaugietis says. “You can have investment returns, or you can contribute to the plan.”

Jaugietis points out that premiums set by the Pension Benefit Guaranty Corporation (PBGC) areset to increase substantially, which in turn increases the incentive to fund the plan earlier or more quickly. The discussion should focus on the best investment strategy and what funding policy will help the firm get to the endgame.

Current trends, according to Jaugietis, include firms asking if they have the right partners or resources to carry through the strategy, and outsourcing to a specialist asset manager for the investment component to provide these services. There is more dynamism in the use of asset classes as well, he says, and plan sponsors are turning to multi-asset investing.

The last component to consider is benefit design, adds Jaugietis. Firms must look at the overall pension benefit. He notes that a number of companies have closed and frozen their pension plans, and provided an additional 401(k) benefit. Comparing it to the three legs of a stool, he emphasizes, “A clear strategy of investment policy, investment strategy and benefit design are necessary.”

More about asset allocation in higher funded pension plans is on Russell’s site.

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