Administration May 28, 2020

How to Manage DB Plans Through the Crisis

Experts expect the market volatility will continue for an unknown amount of time, so DB plan sponsors must be flexible and find new directions depending on the goals for their plans.
Reported by
Art by Bill Mayer

Defined benefit (DB) plan sponsors took an unexpected hit when the market crashed because of the COVID-19 pandemic, and many found past strategies they used in bear markets needed to be tweaked for the unprecedented volatility that followed.

The volatility is likely to continue for an unknown amount of time, and some financial professionals are speculating about whether and when another market fall is likely. An Insights article from Willis Towers Watson suggests institutional investors should adopt the right strategy, investment approach and governance structure for a permanently changed environment rather than building a framework that depends on waiting for a recovery. “Rather, the aim should be to be well-positioned to deal with a continued period of uncertainty, whether this is directly related to the current pandemic or something that is as yet unforeseen,” the article concludes.

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“We do think there will be a lot of uncertainty from here given that there are several different paths the economy can take,” says Jon Pliner, senior director, investments and U.S. head of delegated portfolio management, Willis Towers Watson in New York City. He adds that DB plan sponsors need to manage risk at a total portfolio level.

“When they think of LDI [liability-driven investing], it’s not just segments, but how the portfolio will move with respect to liabilities as a whole,” he says. “With a traditional liability-hedging portfolio, sponsors are looking to manage interest rate exposure, but they also want assets to protect the portfolio overall.”

A New Direction

Al Pierce, managing director at SEI Institutional in Oaks, Pennsylvania, now based in his sleeping porch at his home in Swarthmore, Pennsylvania, says the first thing SEI does with clients to ground the discussion about DB plan risk and asset allocation is discuss what is happening at the sponsor company itself—balance sheets, cash flows and profit and loss (P&L) forecasts can be volatile as well. Plan sponsors’ strategies or policies, as well as LDI glide paths, may have been interrupted.

Answers to questions were more straightforward before the current market environment, but now plan sponsors need to think about taking new directions.

Regarding overall asset allocations, plan sponsors need to ask whether they are in appropriate asset classes, Pierce says. When moving to re-risk—increasing return enhancement or non-LDI assets—the components would depend on funded status. For example, clients that are well-funded would invest in low volatility equities, have limits around emerging markets and have alternative low-beta or non-directional hedge funds. “It’s now less about which asset class will outperform another and more about the risk return profile needed to accomplish the goal for the plan,” he says.

Plan sponsors also need to ask whether their LDI glide path is appropriate, what the risk associated with re-risking is and if they feel comfortable taking that on, Pierce says. Corporate bond spreads have been very volatile because of the COVID-19 pandemic. He notes that the same thing happened during the 2008-2009 financial crisis, but anyone using swaps or Treasuries then outperformed. Now, rates have not moved.

“If a plan sponsor uses an LDI glide path and was 90% funded, it may have had 40% of assets in LDI vehicles. But, now it may be 85% funded. The first question should be how is it going to move along the glide path given the volatile situation now. It may need to stay on its glide path but, if so, expected outcomes will be different—expectations for return and the yield path are different than when the glide path was set. It likely should reduce assets in LDI vehicles,” Pierce explains.

Plan sponsors also may be asking whether they should put money into their DB plans to keep them on the glide path. Pierce says most sponsors that were making discretionary contributions to the plans decided they needed to back off because of uncertainty for their business and the cost of capital. “They need cash for things other than the plan,” Pierce says.

He adds that it is uncertain what the next three to five years will look like for required contributions to plans as well. “2019 was unusual in that asset growth was strong and the calculation of liabilities was strong. This year, discount rates used to measure liabilities are flat and asset values are down. This will impact required contributions,” Pierce says.

While not a new idea, Mike Moran, senior pension strategist at Goldman Sachs Asset Management in New York City, says when DB plan sponsors consider higher funding deficits and higher Pension Benefit Guaranty Corporation (PBGC) variable rate premiums, now may be a time to think about borrowing to fund. “We saw that a lot several years ago, and in the past couple of weeks more clients are thinking about it as deficits have widened,” he says. If they can borrow at attractive rates and contribute the proceeds to their pension plan, they can reduce—or even eliminate—their pension deficit.

Pierce says clients have been discussing their pension risk transfer (PRT) strategies. Due to the dilutive impact of PRT’s when plans are less than fully funded, along with the desire of many plan sponsors to conserve cash and minimize pension contributions, we would expect PRT activity to be low.

He adds that he hasn’t yet seen insurance carriers adjust their underwriting in recognition of the fact that mortality expectations may be higher due to the coronavirus than what they priced in six months ago. “What impact would that have on annuity pricing, and should plan sponsors wait?” Pierce questions.

With volatility here to stay, a new risk factor Kevin McLaughlin, head of liability risk management at Insight Investment in New York City, says plan sponsors need to give more attention to is liquidity. “We had a liquidity freeze in March. Many clients in are in the decumulating phase for their DB plans and they need more liquidity. They need a liquidity buffer going forward,” he says.

All these questions about strategy mean plan sponsors need to ensure they have the proper governance in place and that they can evolve as they need to, Pliner says. “It is important to be able to make quick decisions about the LDI path and to have a framework to take risk off and lower return assumptions but manage risk on an ongoing basis,” he says. “Adjustments to portfolios—undoing de-risking or changing triggers on an LDI glide path, for example—should make sense in the market environment that exist at that point in time.” Pliner says plan sponsors should look both internally and externally to build a governance structure that can make good decisions and take advantage of opportunities when they arise.

Moran says it’s a challenge to be flexible if there is not an internal dedicated team for the plan. Decisionmakers may meet quarterly or may have a one-off meeting sometimes, and they may not even have real-time information to make decisions. “They may need hands on the plan every day now,” he says.

Pierce notes that SEI is an outsourced chief investment officer (OCIO) for its clients. Plan sponsors have to focus on business challenges and want time spent on DB plans to be productive. The value in having an OCIO, he says, is decisions can be more impactful, rather than just determining whether to get rid of an investment or investment manager.

“Plan sponsors’ strategies should be reviewed in light of how their business forecast has changed and the drivers of that—they go hand-in-hand; a pension plan is part of a sponsor’s capital structure. Reflect on how things should be adjusted and what can be done in an environment that will be different for the foreseeable future,” Pierce says. “I am confident that anything in place on January 1 is probably not effective or the right answer given where their business is now.”

Administration May 19, 2020

Advancing DC Plan Design

Many features are working to help DC plan participants grow their savings, so it’s time to look at investments for the next element of design evolution.
Reported by
Art by Wesley Allsbrook

The defined contribution (DC) retirement plan industry continues to innovate to remold and reshape plans to create real retirement security for participants.

As more responsibility has shifted to participants for managing their own retirement savings, it has become obvious that they are not as equipped to do so as those responsible for the management of defined benefit (DB), or pension, plans. So features of DC plans have evolved to mimic those of DB plans.

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Mike Swann, client portfolio manager at SEI in Oaks, Pennsylvania, says the fact that each participant is responsible for his own outcome is one of the things that is not working in the DC retirement plan system. Participants are not familiar with how to set up portfolios to withstand market losses or how to react to market losses, and they are subject to their own whims—taking hardship withdrawals or loans and reducing or stopping contributions when they need cash.

While DC plan design has undergone many changes over the past few decades, one thing that hasn’t changed is the behavior inherent in the majority of people, says Gregory Kasten, MD, CFP, AIFA, founder and CEO of Unified Trust Company based in Lexington, Kentucky. There are five financial behaviors that don’t change that have been well-documented for more than a decade by UCLA professor Shlomo Benartzi along with Richard Thaler of the University of Chicago, Kasten says: inertia, procrastination, choice overload, endorsement and framing.

“Inertia tells us that however a participant is started is how they go. So, if we start them wrong, they generally will not correct, but if we start them right, they tend to stay on the path,” he explains. “Procrastination tells us that we can put in front of someone a reasonable pathway, but if they have to do everything themselves, they will put off doing it. Choice overload is when a participant is given too many choices, he shuts down and makes the simplest choice, which is no choice. Endorsement is when participants think whatever is put in front of them must be right because the [employer/plan provider/plan adviser] wouldn’t put in front of me something that is wrong. And framing is when a certain answer is provided depending on how something is asked.”

Kasten notes that the industry has tried to create tools and calculators in the hopes that participants may be coached out of the five behaviors, but there is very little use of these tools, at about 10% of participants. “The answer is we have to do almost everything for participants. That’s why automatic plan features are working,” he says.

“The effect of wide adoption of auto-features is participants have deemed that is what they should do,” Swann says. “Especially when a plan sponsor automatically re-enrolls employees into a QDIA [qualified default investment alternative], it tells people, ‘This is the right answer and you need to stick with it.’”

Ross Bremen, a partner in NEPC’s defined contribution practice in Boston, says target-date funds (TDFs) “continue to be the answer for most plan participants,” helping them stay the course during challenging times.

However, Bremen points to another thing that is not working for the DC retirement plan system. While plan sponsors may try to provide the right messaging for participants, they get mixed messages in other ways. Regulators and legislators tend to turn to DC plans to provide financial help for employees in times of disaster or emergencies. Bremen specifically points to the Coronavirus Aid, Relief and Economic Security (CARES) Act passed on March 27. “While it may be providing necessary funds for participants, it may also be creating a savings challenge for those who take distributions or loans,” he says. Such legislation sends a mixed message to participants who are told repeatedly to keep their retirement savings invested for the long term.

Bremen points out that there is mixed messaging even within the legislation. “The legislation says RMDs [required minimum distributions] don’t have to be taken, but it opens up other avenues for participants to take their money. I understand the RMD idea is that participants nearing or in retirement need more time to make up for market damages, but even the government in its own rules is sending confusing messages,” he says.

Bremen adds that plan sponsors should provide communications to participants about how damaging withdrawals and loans could be on their retirement savings and about focusing on the long term. They should also be thoughtful about balancing CARES Act relief and retirement outcomes and consider not offering some or not offering all provisions.

Along Came COVID-19

Despite the mixed messaging, Bremen says he doesn’t think the COVID-19 pandemic has revealed that wholesale changes are necessary to DC plan design, as he points out that most participants are staying the course in saving and investing.

Kasten says, if anything, financial crises such as the one caused by the pandemic re-emphasize the five behaviors that DC plan design has been addressing, as those behaviors may become worse during crises. “We found in the first quarter [of this year], if a plan is set up to do everything for participants, there is no spike in calls to call centers and no spike in people wanting to change investments,” he says.

However, even though wholesale changes might not be necessary, the pandemic has revealed a couple of shortfalls in DC plan design, Kasten says. He notes that a study in February revealed that the average person nearing retirement held 78% of his portfolios in stocks. “Most retirement experts would probably say this is too much for someone a few years from retirement. Sequence risk is bad when returns fall shortly before or just as a participant retires,” he says.

Kasten says the pandemic shined a light on the fact that DC plans do not effectively de-risk those closest to retirement. “We measure risk for each participant and put that on retirement plan statements. It needs to be monitored more, because if you don’t measure something, how can you manage it?” he says.

There need to be some structures—risk constraints—that can keep risk manageable, Kasten adds. He says Unified Trust Company uses two strategies to reduce risk for five to six years up to retirement: Participants’ overall asset allocation is changed to lower exposure to equities than the average TDF and stable value funds in managed accounts are used. “Most TDFs don’t hold stable value funds because they are not mutual funds, but stable value is very helpful when, like in the first quarter, the bond market was also losing money. It has a smoothing effect on fixed income,” Kasten says. He adds that this highlights an issue with TDFs—they only consider a participant’s age and not his goals or whether he’s on track to reach his goals.

Another thing the pandemic has revealed, Bremen says, is that there is still a large focus on investment performance and not on replacing monthly income. “It’s the nature of how DC plans are managed, where we have web-based information and people can look at their balances and trade each day,” he says. “That’s not how a pension plan operates. It focuses on long-term income replacement.”

Swann echoes that idea, saying the “focus on TDF performance exclusively is fairly misguided. It gets distorted during long bull market runs. The focus has to be on downside risk management. People retire every day, and, when a month before they retire, they lose 20% of their balance, it drastically changes their retirement outlook. The lack of focus on downside risk creates meaningful and significant impacts on participants.”

He adds, “Each TDF series has a different approach for mitigating different risks near and after retirement. Plan sponsors can see in the dispersion of returns and results of the first quarter how TDF providers manage risk compared to each other. They have to understand the concentration of risk in the portfolio rather than focus on returns and pure rankings.”

The Next Big Focus

Swann says he believes the next big focus for DC plan design will be evaluating downside risk, especially for those closest to retirement.

He says the Setting Every Community Up for Retirement Enhancement (SECURE) Act will help as it allows plan sponsors to explore guaranteed income products. Even if legislative and regulatory hurdles are cleared, however, the pricing hurdle needs to be cleared, Swann notes. “Current costs with commissions in the multiple hundreds of basis points [bps] create a challenge for getting these products into DC plans,” he says. Though some cost is worth the downside protection, cost will have to continue to be compressed.

But Swann says he believes providers will find a way to make products work in a cost-effective manner. “The evolution of DC plan design will be driven by market demand,” he says. “The ‘give as much risk as participants can take to get market performance’ argument is going to change. Providers tend to innovate to where clients want, but they will have to do that in a way that is price competitive. There’s a chance lifetime income solutions will stay outside of plans, but their buying power would drive costs down.”

Kasten says the next focus for DC plans will be how to take accumulated savings and create a lifetime income stream because the way plan sponsors define success is changing. Traditionally, plan sponsors have measured success by participation rate and participant savings rate, but those are not endpoints. “The endpoint is replacing paychecks when participants retire.” He says he believes guaranteed income strategies, lifetime income strategies and payout strategies—“things that make DC plans look more like pensions”—will be incorporated into plan design.

Bremen says he also believes the income focus will include several elements—different types of fixed income offerings, managed accounts, annuity products and an analysis of how solutions fit into DC plans.

He points out that when plan sponsors build their DC plans, they don’t all choose the same features, and he says the same will be true for retirement income. “Not all retirement income products are the same, and not all participants are the same. The evolution of personalization will continue for retirement income,” Bremen says. “The idea that a single solution works for everyone, which historically has been the case for TDFs, will change to give participants the tools they need to craft a solution that is right for them.”

He adds that work is already being done on income solutions, and it will take time for plan sponsors to become educated about and to evaluate the range of solutions available.

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