White Paper Outlines DB Risk Management Strategies

June 5, 2014 (PLANSPONSOR.com) – A white paper on U.S. pensions covers the major themes impacting the funding of defined benefit (DB) plans and strategies to help manage risks.

The last 15 years have seen major shifts in the U.S. and global capital markets, contends Deutsche Asset & Wealth Management in “U.S. Pensions.” Particularly affected by these shifts are U.S. corporate DB plans, which have had to address both changes in the capital markets and in accounting rules, the paper contends. The combination of legislation coupled with accounting changes has heightened the pressure on sponsors to address funded issues.

The purpose in writing the paper was to survey the industry about different techniques companies use to evaluate their funding status and the risks they face, says Michael Earley, head of client solutions, Americas, Deutsche Asset and Wealth Management. Deutsche Asset and Wealth Management observed some of the practices used in European pension plans, Earley tells PLANSPONSOR, and some of the accounting changes that came about as a result of the Pension and Protection Act of 2006 (PPA) have increased the relevancy of some of these techniques.

As the paper explains, the PPA requires plan assets to be equal to 100% of plan liabilities, and for unfunded liabilities to be amortized over no more than seven years. For this reason, liability-driven investing (LDI) is much more relevant, Earley points out, and it’s much more on the minds of DB plan sponsors.

Companies can address funding issues with strategies that either manage the liability or the asset side of the equation. Liability strategies rely on one of three distinct approaches: manage the obligations through direct offers to plan participants, such as a lump sum; transfer risks by an insurance buyout or buy-in of the risk; or rely on changes in discounting methodology.

A section in the paper about discounting methodology explains the thinking behind this strategy, and discusses the Moving Ahead for Progress in the 21st Century Act (MAP-21), the 2012 legislation passed by Congress that included funding relief for pensions.

In general, DB plan sponsors should decide whether pension liabilities should be funded externally or be managed on the balance sheet, the paper contends, because asset strategies are significantly influenced by the funding strategy. When managed on the balance sheet, the asset strategy for those liabilities is usually aligned with the overall treasury strategy for the company.

Several ways to address funding gaps are outlined: through funding plans; through a pure investment performance, by increasing asset allocation to risky or high-volatility/high-return assets, with the expectation of earning a rate of return in excess of the pension plan’s discount rate; or through LDI.

Once assets are either earmarked on the balance sheet to fund the liabilities or the DB plan sponsors decide to use outside funding, they should select strategies that are more aligned to the nature of the liabilities. Discussing asset strategies means taking the characteristics of the pension liabilities into account. Whereas an absolute return strategy targets earning the discount rate, a liability-driven strategy aims to mimic the characteristics of pension liabilities and to minimize the volatility of the funded status.

The paper outlines pros and cons of different allocation strategies. Factors that favor an allocation to fixed income include frozen plan status, with no additional wage-based benefits being accrued; high current funding levels that reduce the need to fund the gap through high returns; and large pension plan size relative to total company market capitalization.

Allocating to equities or other asset classes besides fixed income would be swayed by open or closed status, where accrual of additional benefits exposes the plan to inflation; low funded status where short-term volatility is acceptable to reduce funding costs; or a small pension plan size relative to total company market capitalization.

Expectations of a rising  interest rates  and the challenges of the current low interest-rate environment are both discussed strategically, with the advantages of low borrowing costs for companies that want to leverage the bond market. Companies with high credit ratings may find that debt issuance can be earnings- and tax-positive, the paper states.

“The recovery of equities market has put a lot of plans back on firmer footing,” Earley says. “Now they have a chance to see what their objectives are with their pension plans.”

The paper was co-written with Martin Thiesen, global head of liability-driven solutions at Deutsche Asset & Wealth Management, and Kevin McLaughlin, U.S. head of pension risk management at Deutsche Bank Securities Inc.

“U.S. Pensions” can be downloaded from the website of Deutsche Asset & Wealth Management.