‘Hibernation’ the Next Step for DB Plan Investing

Robust bulk pension buyout activity led to an increase in deal flow of $23.3 billion for 2017, composed mostly of retiree-only buyouts, according to Mercer.

The Mercer/ CFO Research 2017 Risk Survey indicated that 55% of defined benefit (DB) plan sponsors are likely or very likely to annuitize some or all of their obligations in the next five years.

In a new white paper, Mercer says that due to this activity, it has seen some strains based on current demand. “The insurance market for deferred benefits in particular is feeling pressure, and we see this challenge becoming more widespread in the near future,” Mercer says.

According to “Pension Investing for the Long Term: An Alternative to Risk Transfer,” as more marketable obligations—such as those for in-pay retirees—are transferred to insurers, residual DB plans will have unusual and idiosyncratic features that make them more difficult to manage. This latter challenge of steady-state pension management will drive pension investing to a “hibernation” focus for many.

Mercer suggests pension sponsors should now focus on the shakeout that lies ahead, with the potential bifurcation between liabilities sold to insurers and the hard stuff kept on pension balance sheets. As more sponsors look to self-insure their obligations, hibernation investing will begin to dominate the pension investment landscape. Mercer explains that hibernation investing involves putting plans in a steady state while winding them down over time and/or gradually preparing for pension risk transfer over a longer period of time. Although very similar to traditional liability-driven investing (LDI), hibernation investing will not be as simple—it brings its own set of challenges and risk-management opportunities.

For a plan entering a hibernation period, four key priorities come to the fore, according to Mercer:

• Minimize residual expenses, whether investment, Pension Benefit Guaranty Corporation (PBGC) premiums or other administrative costs;
• Maximize their asset returns in a low-risk state through active management and diversified sources of return where appropriate;
• Minimize residual risk in the end state through a tailored investment strategy by keeping asset and liability returns as closely aligned as possible, as well as focusing on demographic risks; and
• Ultimately, minimize the capital deployed in excess of pension obligations to keep the plan self-sufficient in a low-volatility state, accounting for the plan’s residual costs and risks.

These priorities involve several tradeoffs that will lead to different outcomes for different sponsors, according to Mercer. The higher the net investment return generated, the lower the need for capital. Similarly, the tighter the hedge in the investment strategy, the lower the downside risk and, therefore, the lower the need for excess returns and/or capital commitments. So the first steps in a successful hibernation strategy are to determine the target parameters around these factors and then manage to the resulting benchmarks effectively.

The white paper discusses strategies and considerations for the four priorities and may be downloaded from here.