How Higher Interest Rates Are Changing Focus of Fully Funded Pension Funds

Fully funded due to higher discount rates and investment performance, many corporate defined benefit pension funds are shifting their investment goals to maintaining that funding progress, from their prior focus of maximizing investment returns.

While many have had significant assets dedicated to liability-driven investing in recent years, they are finding it is time to acknowledge the higher-yield, better-funding environment. As a result, a common approach among the cohort is to examine “overlap in plan holdings, inadequate hedging of liabilities and insufficient downside protection in their LDI manager lineup” to secure their funded status gains, according to a paper authored by Todd Glickson, head of North America investment management at Coalition Greenwich, a division of CRISIL, an S&P Global company.  

“These pension plans that are now more than fully funded have to think about managing the plans a bit differently than they did X, Y years ago,” Glickson says. “[Funded] DB plans [are] moving to a different phase in that life cycle.”

Rising interest rates have driven 70% of corporate pensions plan sponsors to review their liability-driven investment manager selections, because of their gains in funded status, to ensure they can reach plan goals, found the study, “Corporate DBs Move to Secure Funded Status Gains and Begin Endgame,” based on a report commissioned by Franklin Templeton.

Almost three-quarters of the 30 institutional investors at corporate DB plans taking part in the study reported funding ratios of 100% or greater, 23% of plans reported funding ratios greater than 110% and only 27% of plans reported funding less than 100%.

According to the Milliman 100 Pension Funding Index, which tracks the average funded status of the 100 largest U.S. corporate pension plans, funded ratios surpassed 103% in September, as compared with just 88% at the end of 2020.

Funded pension plans “[are] more focused on things like risk management or downside protection, where before they were trying to get to the [funded status] goal,” Glickson says. “You’ve reached the promised land, so to speak; how do you stay there?”

Consequently, DB plan managers are “contemplating changes,” he adds.

Corporate DB plans that have moved from “underfunded to fully funded” may seize on this time to change course and re-evaluate their current LDI manager lineups because there may be allocations that overlap or allocations with “higher correlation among those LDI managers,” advises Glickson.

“The changes they’re contemplating are about adjusting the duration to more closely match liabilities, improving downside risk protection, increasing manager diversification, [and] all of those things to really go from one stage to another stage,” he adds.

The survey asked respondents what changes they are contemplating—if the institutional investors answered “yes” to the question, “Have you/are you contemplating changes within your LDI program?” according to a Coalition Greenwich spokesperson. From a list of options, respondents were asked to select all options that apply, and the changes investors said they are contemplating included:  

• Adjusting duration to match liabilities more closely (56%);
• Improving downside risk protection (44%);
• Entering into either a hibernation or pre-PRT mode (22%);
• Increasing manager diversification (11%);
• Lowering fees (11%);
• Hiring an LDI completion manager (11%); and
• Other changes (22%).

The qualities DB plans are examining when selecting LDI managers for the next phase of their pension investment focus included:

• Risk management (96%);
• Fees (70%);
• Knowledge and understanding of key pension risk management elements (70%);
• Diversifying current lineup (33%);
• No, or limited, style drift (26%); and
• High alpha (15%).

Fully funded pensions are “evaluating if they need to diversify their portfolios by adding new managers with investment philosophies and styles less reliant on credit beta,” Glickson wrote in his paper. “For example, integrating advanced portfolio construction techniques as a primary source of alpha can provide both enhanced diversification and downside risk mitigation to an existing multi-manager liability-hedging portfolio.”

The risks most cited for the current LDI manager lineup included:

• Substantial overlap in holdings among managers (43%);
• High correlation between fixed-income LDI managers (29%);
• Inadequate hedging of liability due to off-benchmark exposures such as high-yield, emerging market debt and others (29%);
• Inadequate downside protection when markets sell off (29%);
• Portfolios not sufficiently seeking alpha (19%); and
• Most managers tend to be “risk on” at all times (10%).

Coalition Greenwich conducted 30 interviews with institutional investors targeting key decisionmakers at corporate DB plans based in the U.S. from August through October to understand how they manage diversification and plan/funding risk, select an LDI manager and navigate overall risks on the economic horizon. As part of the study, Coalition Greenwich also held in-depth discussions with investment consultants. The study is based on a report commissioned by Franklin Templeton in August.