Past Bear Market Strategies No Comfort for DB Plans Right Now

Pension plan consultants are tweaking recommendations for DB plan sponsors during the unprecedented volatility created by the coronavirus pandemic.

Market volatility is not new to defined benefit (DB) plan sponsors. The market volatility caused by the novel coronavirus pandemic, however, is unlike anything they’ve ever seen.

Brian Donohue, partner at October Three Consulting, based in Chicago, says he believes DB plan sponsors have learned some things about risk in this century. “If we look at 1999 before the dot-com bubble burst, more sponsors were taking risk; they held 70% or 75% in equity. After that crisis, sponsors learned not to creep too far out on the risk continuum. So, when 2008 [the Great Recession] came along, they were not as exposed to the stock market, and evidence shows that since then sponsors have not increased their allocations to risk,” he explains. “There hasn’t been a wholesale movement to LDI [liability-driven investing], but I would bet most plans have only 50% to 60% or less of assets in stock. They may have been better prepared to weather this downturn.”

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Donahue says if DB plans were just invested in bonds, they would have been insulated from the major swings in the market. “That’s always been the case and always been an option for DB plan sponsors—to just invest in bonds. That’s the idea behind the liability-driven investing glide path; once a plan hits a certain funded status trigger, more assets are moved into bonds to preserve the funded status,” he says.

Jeff Passmore, director, client portfolio manager and LDI strategist at Barrow, Hanley, Mewhinney & Strauss in Dallas, Texas, says plans using liability-driven investing are faring “quite a bit better” than those that aren’t using it. “The bond portion of any DB plan’s portfolio is doing what it should—reducing volatility and protecting asset returns,” he says. “Thinking about risk beyond asset losses to funded status, bond portfolios are helping to protect funded status.”

Passmore speculates that a lot of plan sponsors had been hoping that the great bull market would continue, so they left some risk on the table. “They are probably regretting that now since the high-water mark in terms of funded status—according to Barrow Hanley, 88.7%—was at the end of last year.”He explains that triggers for de-risking are usually spaced out 5 percentage points, so a plan sponsor just short of a 90% funded status trigger is probably regretting not taking risk off the table. “In my estimate, funded status went down more than 10%,” he says.

Plans with LDI are doing much better primarily because of bond investments, but how they are implementing their bond investment matters, says NEPC Partner and corporate practice group member Brad Smith, based in Atlanta. “Treasury bonds have done very well year to date. Long credit is positive but not as strong because credit spreads have widened,” he explains. “So not only has an LDI strategy helped DB plans, but those with Treasury allocations rather than just long credit allocations have fared better.”

Not the Same Messages

Donohue says pension consultants are in an interesting situation right now. “Our first reaction is to tell clients, ‘There’s a hole in your pension plan and you should think about filling it,’ but for most companies, the pension plan doesn’t rank first in terms of all they are worrying about right now,” he says. “Some may be worried about making payroll or whether their company will survive, so understandably there’s a premium on cash. Firms don’t know what’s going to happen. Filling in for losses may be more front of mind for those working on the plan, but not for the overall company.”

In addition, for a company on a glide path that was 90% funded and maybe 70% invested in bonds but is now 85% or 80% funded after the stock market drop, Donohue says logic would indicate it should put more money in stocks. “But not a lot of people are hawking that idea,” he says.

Donohue adds that during the depth of bear markets in March 2002 and March 2009, it was a good time for DB plan sponsors to move more assets into stocks. “The idea was that as we climbed out of the bear market into a better year, DB plans would have a better rebound with more assets in stocks,” he explains. “There’s logic to it, but it’s a tough conversation and tough sell right now.”

Passmore says most plan sponsors using an LDI glide path with defined funded status triggers to take de-risking steps think of their de-risking journey as a one-way street, so most have decided they do not intend to re-risk. However, a minority have come to the opposite conclusion and will move to more return seeking assets as funded status goes down.

“Corporate plan sponsors are relatively slow to make changes, so they will make decisions in a couple of weeks as they have meetings and their consultants make recommendations,” he says.

There are several approaches to reduce pension funded status volatility that have been touted, Passmore says, “but what we’ve seen is most return-seeking assets have very correlated downsides—as the stock market experiences a sell-off, so do return-seeking assets.”

Specifically, Donohue mentions DB plan sponsors’ interest in private equity and hedge funds. Private equity is similar to investing in emerging markets, he says—there’s more risk and less liquidity so the assumption is it will result in a better return. As for hedge funds, Donohue notes they did very well in the last financial crisis but have fared less well since then. “I haven’t seen any hedge fund data for first quarter yet. Returns are probably not great, but better than the stock market,” he says.

Passmore says long-duration corporate bonds are thought of as the gold standard for preserving pension funded status in down markets—yields correspond with DB plan liabilities; it’s the ideal hedge.

A flash poll by NEPC found the majority of plans are not taking any actions right now related to the market volatility caused by the pandemic, but 35% of plans with less than $1 billion in assets and one-quarter of plans with more than $1 billion in assets indicated they are rebalancing to their target allocations. Smith says during prior market crises, NEPC clients did rebalance but at a measured pace. However, the speed of this drawdown was faster than what many expected.

“With the current volatility, plan sponsors don’t want to trade today then have to reverse it,” he says.

A small percentage of plans in the flash poll indicated they were taking actions to raise cash. He says that is what NEPC is advising clients to do right now. If they have a mature plan with material payments, NEPC recommends a 1% to 2% cash holding.

Considerations for DB Plan Contributions

As for the hole consultants would usually tell plan sponsors to think about filling, Donohue says one of the “useful messages we are trying to put out is that anything that’s happened in 2020 will not affect contributions until April 2022.” In an article on October Three’s website, Donohue says, “Funding requirements for 2020 for a calendar year plan were locked in as of January 1, 2020. 2020 asset declines may affect minimum funding as early as 2021. Interest rate declines won’t show up in minimum funding numbers until 2023. If they persist.”

The bottom line is there is no need for an immediate cash response to what is happening now, he says, which is good to know because plan sponsors have other concerns right now.

Donohue also mentions the relief provided in the Coronavirus Aid, Relief and Economic Security (CARES) Act. Section 3608 of the CARES Act provides a delay for minimum annual required contributions (ARCs) that would otherwise be due from single-employer DB plans during this calendar year. The new due date for any such contribution is now January 1, 2021.

Yet, Donohue says, he is always talking to sponsors about why it makes sense to put money in their DB plans. “On September 15 of this year if they can swing it, sponsors should consider putting money in their plans for the same reasons as always—being underfunded and major PBGC [Pension Benefit Guaranty Corporation] premium costs. But as always, they will weigh that against other clamors for cash,” he says.

Asked whether DB plan sponsors may consider making additional contributions to make up for market losses, Passmore notes that for most plan sponsors, contribution requirements are quarterly with the largest due at the end of the third quarter, so sponsors have a little bit of time.

However, he says, “I don’t think anyone is prioritizing pension contributions at this time. What we have seen in the last several weeks is companies issuing bonds and tapping credit lines in record numbers, so I think companies are doing what they can to create cash reserves to handle expenses until the economy comes back around. Pension plan contributions tend to fall much lower on companies’ list of priorities and can wait until a later time,” Passmore adds.

While the CARES Act included a provision to allow some plans to avoid triggering certain benefit restrictions in 2020 that would otherwise apply if their funded status falls below 80%, it did not include funding relief as seen in prior market crises. Passmore says he wouldn’t be surprised if Congress passed some additional funding relief for DB plans, since such moves have been typical during certain market events. He says he expects some broad funding relief as well as perhaps more targeted funding relief. “For example, airlines post-9/11 were given more relief, and that is beginning to sunset,” Passmore says. “Given what they are facing now, I would not be at all surprised to see more targeted relief for airlines and potentially other hard-hit industries.”

The bottom line is there’s a huge amount of uncertainty right now, Donohue says. “It’s such a volatile period it’s hard to make too many specific, concrete decisions. Waiting and seeing might be the best thing to do right now,” he says.

Smith says the most important thing for DB plan sponsors is to stay disciplined. Rather than a specific target, plan sponsors’ allocations should stay within target bands. “The stock market not only sells off before a recession but recovers before we get out of a recession,” he notes. “If a plan’s allocation is outside target bands, plan sponsors need to rebalance and get closer to the target, but don’t trade just to trade.”

Passmore says this event and other great financial crises point to the importance of understanding financial risk taking in DB plans—ensuring plan sponsors are comfortable with the risk and looking at to what extent they are not managing it. He adds that the primary way to manage risk is an LDI approach using glide paths.

Passmore suggests DB plan sponsors work with their partners—consultants, outsourced chief investment officers (OCIOs), investment managers—to monitor funded status and facilitate quicker moves at triggers so opportunities are not missed.

Talking Points to Help Participants Navigate Market Volatility

Certain concepts should be communicated clearly to retirement plan participants so they don’t make decisions that may hurt their retirement readiness.

With the recent bouts of turmoil, understanding market concepts can prove more overwhelming than ever for participants.

Recognizing the difference between a bull and bear market, examples of risk tolerance and market volatility, and how it all ties into retirement are focuses employers are diffusing to employees, along with how they can seek more information on these topics, whether it’s through increased communication efforts or by seeking advice from a financial adviser.

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“Recordkeepers and advisers in the marketplace have provided additional call center support or financial wellness solutions that are aimed at providing participants with an additional resource to manage the markets,” says George Sepsakos, principal at Groom Law Group. “Others have teamed with the plan sponsor’s human resource [HR] personnel to better manage participant questions.”

Market Volatility

Among the most important topics is market volatility and how its swings can and will affect retirement accounts. Volatility heavily impacts stock market performance and thus affects investment risk, but just because markets are irregular, it doesn’t mean participants will only see negative returns. Investors still have the opportunity to gain. A Hooker & Holcombe report notes how during fluctuations in market downturns—including the 2008 market crash and the Great Recession—the average growth rate of the S&P 500 produced positive annual returns.

Participants are advised to look toward their long-term financial goals, which includes retirement. “Some plan sponsors have taken this opportunity to remind participants of some basic information about their retirement plan and that their plan is intended to be a long-term investment,” Sepsakos says.

While plan sponsors and financial advisers can understand the fret among investors, Sepsakos urges employers and industry professionals to remind their workers to stay calm during choppy markets. “In this vein, plan sponsors have sent communications to participants that encourage them to ‘stay the course’ and not pay attention to short-term volatility in the marketplace,” he adds.

For those unfamiliar with financial concepts such as market volatility, Megan Yost, vice president of communications at Segal Benz, a benefits communication firm in San Francisco, recommends plan sponsors apply visuals to education guides. As employers are now increasingly communicating via online tools and social media, adding graphics and charts clarifies otherwise complex subjects. For example, “if they can see how an historical downturn affected the markets, that can really help them,” Yost says.

Surveying the Market

Similarly, participants will want to learn how surveying the market could add to their losses or gains. “To help weather difficult market turns, portfolios should reflect both a risk and asset allocation approach,” Hooker & Holcombe reports. Diversifying portfolios with stocks, bonds, cash and alternative asset classes creates a well-mixed balance.

For this talking point, Yost mentions using and defining common financial terms—such as stocks and equities—for those unfamiliar with the concepts. Learning about investment terms can lead to confidence in the markets.

Dollar-cost averaging, for example, may sound complex, but is a fairly simple investment strategy applied in most 401(k)s, in which fixed dollar amounts are invested in the same fund or investment asset over a long period. The goal is to smooth the overall impact of volatility on the price. Instead of making one lump-sum investment in a poor market, for example, multiple smaller investments are made during each market period.

“These terms can be confusing—you want to define them upfront and use them consistently,” Yost adds.  

Risk Tolerance

Risk tolerance, an investor’s aptitude to handling investment losses or gains, is another concept participants often misunderstand. “They usually don’t know what this means, but if you talk about their horizon in risk, that could give participants a better sense of what the term means,” Yost proposes.

While associated with investments, risk tolerance examines more of the investor’s psyche—how the investor portrays loss and the reactions to it. Understanding risk tolerance allows investors to examine how they accept potential loss in the markets, especially during times of market volatility. “It’s best to have a lot of communications about volatility and how to manage through these times,” Yost says.

Because participants are more likely to deal with losses now, she notes that it’s normal for most investors to feel anxiety. “When we experience a loss, it’s more powerful than gaining, especially when we’re watching the market fluctuate,” she adds.

Early Distributions

If participants choose to take an early distribution out of their defined contribution (DC) plan, it’s important for plan sponsors to discuss the consequences of doing so. Taking money out of the markets means participants could lose out on upturns.

While the Coronavirus Aid, Relief and Economic Security Act (CARES) Act allows for the 10% early withdrawal penalty to be waived on withdrawals up to $100,000, this only applies to participants who qualify for COVID-19 relief. Additionally, income tax on a distribution would still be owed over a three-year period. Unless the money is absolutely needed for a coronavirus-related occurrence, it’s best to avoid taking a distribution, Sepsakos says.

“Communications should encourage participants to think carefully before taking distributions or plan loans, and that it’s generally more advantageous to not take a distribution or loan unless they really need the money for an emergency,” he explains.

Avoid Giving Up

According to the Hooker & Holcombe report, after the 2008 stock market crash, a study found 27% of respondents either stopped saving for their retirement or avoided adding to their DC plan contributions. However, a Fidelity Investments report at the time found that the average 401(k) retirement plan balance rose by 466%, to $297,700 between 2009 and 2019. This shows how the market rebounds after a downturn.

Promoting financial counseling and resources and providing education on the markets can prevent plan participants from making rash decisions. Encouraging virtual one-on-one meetings with the plan’s provider or with a qualified financial adviser and adding webinars, articles and the contact information of plan administrators can also thwart anxiety.

“Employees always need to know where to find information. That’s the big thing that employers are trying to help their employees figure out,” Yost says. “They’re leading participants to that type of content now.”

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