A Shift in DB Investing Strategies Expected in 2016

In the past couple of years, a big focus for defined benefit (DB) plan sponsors has been the interest rate environment. Rising interest rates may be a reality for 2016, says Michael A. Moran, senior pension strategist at Goldman Sachs Asset Management (GSAM) in New York City.

Jeff Coons, president of Manning & Napier in Rochester, New York, agrees: “We’ve been talking a long time about what happens when the bond market gets more volatile. We will now see plan sponsors forced to address it.”

Since DB plans have a natural time horizon and duration of liabilities, fixed-income investing is to some extent in bonds, but plan sponsors must consider asset return assumptions, and a rising bond environment can be a drag on absolute returns, according to Coons. “We’ve bee talking about what can happen for a few years, but translating it into mandates for portfolios hasn’t occurred. With bond market risk more front and center, plan sponsors will have to address allocations to fixed income.”

The benefit of long-duration bonds in a falling rate environment is important to keep up with liabilities, but it will turn the other way with rising rates, Coons says. He contends there will be more focus on a Barclays-type benchmark. “We will see more active mandates and nontraditional and unconstrained bonds. As an analogy, over time equity allocations have moved from hiring managers whose performance looked a lot like their benchmarks and turned out little value to managers performing above their benchmarks. The same trend will happen with bond allocations,” he tells PLANSPONSOR.

Moran says preparing for a higher rate environment will be a catalyst for a shift to more fixed income. GSAM is seeing continued interest in unconstrained fixed-income strategies that give managers more room to address duration. In addition, they are adding one or two more fixed-income managers to their portfolios to increase fixed-income holdings from, for example, 40% today to 50% next year and 60% thereafter.

With rising rates, it will probably be a tougher return environment in the next couple of years, Moran says. For many plans, this is a risk management exercise; he notes that on an aggregate basis, DB plans are about 83% funded, same as last year, so plan sponsors need return. Plan sponsors should look to shifting equity exposure to protect from downside risk; hedging and smart beta strategies are being used.

Many corporate and public DB plans have reduced their long-term return assumptions, but it may still be a challenge to hit those, Moran predicts. He says passive management has worked for corporate plans the past couple of years, but now they need active management, or to use asset classes such as real estate, private equity or emerging market debt.

Public plans, in general, have always been more return-focused than corporate plans, as more corporate plans are closed or frozen, Moran notes. With a longer term time horizon, and many public plans not well funded, as well as the expectation of a more muted return environment, GSAM has seen them expand their use of alternative investments. 

With the divergence of performance in the developing world, Coons expects plan sponsors will rebalance their portfolios to take advantage of what is growing. He notes that before and shortly after the credit crisis, there was a big push to make emerging markets a larger percentage of DB plan holdings, since that was where growth was expected to be. However, since 2011 and 2012 emerging markets have shown a dramatic underperformance, and now there are lower allocations to emerging markets across the pension universe.

“My guess is that there will be a need to rebalance to bring back some of these allocations, but the focus will be on more active mandates,” he says. Coons also notes that growth is coming from the consumer and sciences sectors, so it’s likely mandates will take advantage of emerging markets and consumer-oriented growth.

Changes in the regulatory environment—funding relief and higher Pension Benefit Guaranty Corporation (PBGC) premiums—are enhancing risk transfer activity, either lump-sum offerings or annuitization, Moran tells PLANSPONSOR. Investment strategies can help prepare portfolios for risk transfer, and after risk transfer, liabilities will be different so portfolios will have to change.

If preparing to purchase an annuity to transfer some pension liabilities, how the plan sponsor pays for the contract will affect pricing, according to Moran. “Typically plan sponsors are paying out of plan assets, so they need to look at what securities in the portfolio are more attractive,” he says. After the transfer, since usually plan sponsors only transfer part of the plan to an annuity, plan sponsors need to change their asset allocations to match the different liability.

When offering lump sums to a group of DB plan participants, plan sponsors will be liquidating a substantial portion of their portfolios. Moran says they need to anticipate from where they will withdraw assets. “They will want to draw from the most liquid assets, so they are not paying a spread. They need to consider how this will affect the remaining portfolio after the lump-sum window.”

Moran concludes that there is always something going on in the markets, but a confluence of factors, particularly on the regulatory front, means we will see DB plan sponsors doing some different things in 2016.