Defined Benefit Plan Sponsors Should Reassess Their Investments

Willis Towers Watson offers 10 suggestions for DB plans for 2021.

In light of the coronavirus pandemic and the subsequent lockdowns and pivot to working from home, Willis Towers Watson has issued a report, “Top 10 Investment Actions for DB Plans in 2021,” intended to help guide the decisions of defined benefit (DB) plan sponsors.

The first thing Willis Towers Watson suggests that DB sponsors do is enhance the governance structure and the framework of their plans. Sponsors should pay particular attention to re-risking, rebalancing and raising liquidity, because those plan sponsors that rebalanced their portfolios following the market sell-offs in March were able to capitalize on the rebound that happened shortly thereafter. Willis Towers Watson also suggests that sponsors might want to consider moving to an outsourced chief investment officer (OCIO) model.

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Second, the consultancy says sponsors should leverage manager skill and specialization. Specifically, Willis Towers Watson says that while many sponsors might have passive equity and bond investments, they “may lead to more risk and return concentration than intended, [and] for bond investments, passive management may not adequately compensate for downgrades and defaults.” Now may be a good time for sponsors to reconsider active managers, the report suggests.

Third, Willis Towers Watson recommends integrating diversity and inclusion (D&I). While this has been a hot-button issue for how organizations are run and there have been calls to increase diversity in personnel, it can also be applied to pension assets in terms of being well diversified. This includes measuring diversity and examining requirements for new managers, the report says.

Fourth: Reassess risk tolerance. COVID-19 has brought changes to companies’ business risks. This inevitably affects their benefit plans, Willis Towers Watson says. Now is the time to do a thorough asset-liability study.

Willis Towers Watson’s fifth suggestion is to harness illiquidity, namely private equity, real assets and private debt.

Point number six: Flex your assets in line with broader plan management. By this, Willis Towers Watson means that assets should efficiently reflect a pension plan’s funding situation, progress and planned and unplanned lump-sum distributions. Make sure that asset and liability teams are working in tandem.

Achieving the best bang for your buck is recommendation number seven. Think beyond return seeking and liability hedging assets. “For example, long Treasuries hedge a significant percentage of the volatility of liabilities while also benefiting from a flight to safety during a crisis,” Willis Towers Watson says. “This can free up additional capital to target more return-seeking assets.”

Willis Towers Watson’s eighth suggestion is to exploit unpredictability. “Market disruption seems to be part of the new world,” the consultancy says. “Monetary and fiscal policy stimuli are interrupting traditional business cycles.” Sponsors should turn to less cyclical investments and consider how cities will be impacted if virtual work and suburban flight are permanent.

Nine: Include sustainability investing in the portfolio. The report says sponsors should consider how to include environmental, social and governance (ESG) investing in the portfolio.

Finally, reassess fees. The lowest fees are not necessarily the best. It might be smarter to pay a little more in investment fees for talented, active or specialist portfolio managers, Willis Towers Watson says.

Vanguard Tests Approach to Decumulation: The ‘Dynamic Spending Rule’

Simply put, the strategy prescribes lowering spending following market declines to help preserve the balance of a portfolio, which, ostensibly, stands to benefit from market rebounds, Vanguard says.

In a new report, “Guiding Your Clients Through Stormy Weather: Sustainable Withdrawal Rates in Times of Crisis,” Vanguard explores options retirees have at their disposal to preserve their savings and make their money last when there are sharp market downturns. Vanguard said it decided to conduct the research and issue the report after the coronavirus caused U.S. equity markets to tumble 35% in just 33 days between mid-February and mid-March.

Vanguard says the amount an investor can safely withdraw from a portfolio depends on the size of their portfolio and its expected returns. While a market shock reduces a portfolio’s value, Vanguard says, securities with values that have been lowered are inevitably going to rebound, potentially offsetting some of the decline. “A decline in stock market valuations has tended to be associated with higher future returns,” Vanguard says in the report.

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“Vanguard models this dynamic in the Vanguard Capital Markets Model (VCMM), a proprietary forecasting tool that provides investors with a range of possible future expected returns for a wide range of asset classes,” Vanguard continues. “In December 2019, the VCMM projected a range of 30-year returns for U.S. equities with a median projection of 6.1%. In March, following the market shock, the VCMM projected a higher range of future returns, with a median forecast of 8.3%. … In the VCMM simulations, the rise in expected returns meant that the decline in sustainable spending was shallower than the decline in the portfolio’s value. At the end of December 2019, VCMM projections suggested that a $1 million portfolio could sustain $45,000 in annual spending. After the market shock, the $1 million portfolio fell to $800,000, a 20% decline. However, as expected returns rose, sustainable spending dropped by less than 10%, to $40,800.”

Vanguard has come up with a dynamic spending rule that balances the objectives of two popular theories about how to drawn down an account in retirement. The first is the “dollar plus inflation” rule, whereby person sets a dollar amount they want to live on each year and increases it along with inflation as time goes by. Another strategy is the “percentage of portfolio” rule, whereby people spend a fixed percentage of their account. However, if the portfolio declines by 30%, spending must also decline by this much.

To implement the dynamic spending rule, a retiree would calculate each year’s spending by setting a collar—say, a 5% ceiling and a negative 1.5% floor—that gets applied to the ending balance of the portfolio the previous year. If the new spending amount exceeds the ceiling, then spending will be limited to the ceiling amount. If it falls below the floor, spending will be maintained at the floor amount. Vanguard says this makes spending relatively consistent while taking financial market performance into account to help preserve the remaining portfolio.

Vanguard applied this principle to a $1 million portfolio prior to the crisis and found that annual spending would range between $45,000 and $52,000. Applying several scenarios to the portfolio post-crisis, spending would range between $39,200 and $47,200. “After the shock, spending declines, but it remains consistently higher for dynamic spending,” Vanguard says. “By trimming spending when returns are poor, dynamic spending preserves more of the portfolio to compound when returns are strong.”

In conclusion, Vanguard says, “Market shocks are unsettling, but their impact on retirement spending can be managed. On average, a decline in market valuations has been associated with a rise in expected returns. A dynamic spending strategy can position a portfolio to benefit from these potentially higher returns and protect a portfolio’s long-term spending power.”

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