DB Plan Sponsors Should Balance Four Levers to Improve Funding

Even amid a surging bull equity market, the average funded status of U.S. defined benefit (DB) plans has risen by only 2% in the last eight years, from 79% to 81%, according to global investment firm Cambridge Associates.

In a report, “A Balancing Act: Strategies for Financial Executives in Managing Pension Risk,” the firm said DB plan fiduciaries should coordinate across four “levers” that can help improve funded status and mitigate negative impacts of under-funding on corporate financials.

These levers are:

• Asset Returns: Maximizing investment returns from growth assets, like public equities and alternative investments;
• Liability Hedges: Optimizing investments in liability-hedging assets, such as bonds, to hedge key liability risks, including interest rate risk;
• Contribution Policy: Having an established plan and set of guidelines around when and how to make incremental corporate contributions to the plan; and
• Benefit Management: Altering future benefit structures, policies, or strategies.

No lever alone is enough to close the pension funding gap, according to the report. For example, consider a hypothetical defined benefit plan that is 80% funded ($1 billion liability; $800 million in assets). To reach 100% funded status in five years, relying only on growth asset investment returns would require an unrealistic 15.7% return in each of the five years. Similarly, it would take an unlikely 5.5% increase in interest rates over five years for the liability to shrink and close the funding gap. This hypothetical plan would need to contribute $67 million per year to close the gap with contributions alone.

Considerations for each lever

The report outlines considerations that CFOs and financial executives should keep in mind for each of the four levers. For one, creative use of illiquid and other strategies can help grow plan assets.

According to the report, returns from growth-oriented asset classes are the primary engine with which DB plans can grow assets relative to liabilities and close their funding gaps. But over the next 10 years, Cambridge Associates’ analysis projects low-single digit returns from traditional growth assets, such as global equities, which will not be enough for most plans to meet their spending requirements. Plan sponsors may benefit from looking to private equity and other illiquid asset classes, which have historically outpaced traditional assets’ returns and which are expected to outperform by even wider margins in the decade ahead.

Most corporate pensions in the U.S. can likely afford to invest more in illiquid investments than they think, the report says. And, by under-allocating to these investments they may be exposing their plans to unnecessary risk. Also, some growth portfolio assets can act as liability-hedging or “de-risking” assets; these investments allow plan sponsors to hedge against interest-rate risk without reducing allocation to growth, essentially “having one’s cake and eating it too.”

Secondly, mismanaging liability hedges can actually raise portfolio risk. According to the report, while liability-hedging assets, such as longer-duration bonds, can minimize the effect of interest-rate changes on the value of the plan’s liabilities (and therefore how it appears on the company balance sheet today), many DB plan sponsors may not be fully hedging their liabilities, betting too much on interest rate increases in the near future. If long maturity rates do not rise or rise very slowly, the value of liabilities may grow faster than plan assets, which could negatively impact balance sheets.

The report also says employer contributions into a DB plan are probably the most direct link between a company’s balance sheet and its pension, and there are regulations that govern the minimum annual contribution employers must make into their plan. Some financial executives may be tempted to follow the minimum funding levels required by the government, but those amounts may not keep the plan well-funded over the long term. Sophisticated financial executives also remember that they shouldn’t do too little in steady times, because if their company faces financial issues down the line it will only make it harder if they’ve been under-contributing to their pension in more profitable years. On the other hand, capital infusions to a plan are irreversible and will always represent a trade-off versus other strategic corporate investments. A well-articulated contribution policy should balance payouts with other company priorities, within the context of market cycles.

According to Cambridge Associates, benefit management decisions can help refine future obligation costs. Whether a DB plan is fully frozen or still accruing benefits in some fashion, the plan sponsor does have many choices at its disposal in terms of how to manage future plan benefits and their effects on the balance sheet, the report says. These choices vary, and include changing the benefit structure, offering different benefit payment options, various risk transfer tactics and other techniques. Each of these alternatives carries with it both direct and indirect costs and risks; however, that should be fully understood, quantified, and reviewed in an organization’s benefit management policy.

“There is no single answer to the funding gap problem, and focusing on any one lever is neither practical nor cost effective. The most productive outcome depends on a blend of all four in a way that reflects the unique objectives and circumstances of each organization,” says Jeff Blazek, managing director in the pension practice at Cambridge Associates, and an outsourced chief investment officer for the firm.