LDI the Key to DB Plan Funded Status Gains

In an environment where defined benefit (DB) plans are experiencing increased costs and declining discount rates, a survey of corporate and health care DB plan sponsors from NEPC reveals plans’ funded statuses have improved since 2017.

Fifty-eight percent of plans have a funded status greater than 90% in 2019, compared to just 46% in 2017. About three-quarters of plans with a funded status of 90% or higher have utilized liability-driven investing (LDI) and two-thirds have 40% or less of their assets allocated to equity.

Among plans that use LDI, 44% have an LDI allocation of 51% or higher, compared to just 37% and 9% in 2017 and 2011, respectively.

“The correlation between strong funded status and the use of LDI illustrates that risk management in the form of LDI works to reduce funded status volatility in a declining interest rate environment,” says Brad Smith, partner in NEPC’s Corporate Defined Benefit Group. “While the use of LDI has remained consistent with prior years, we’ve found that the allocations to LDI have increased significantly over the past two years and are a key contributor to protecting funded status in this market environment.”

The survey also demonstrates that traditional alternative investment strategies remain popular, as nearly two-thirds of respondents (65%) have an allocation to alternative investment strategies in 2019. Among plan sponsors who are actively investing in alternatives, 40% utilize hedge funds, 38% invest in private equity, and 33% have an allocation to real assets.

While plan sponsors have placed a strong emphasis on evaluating risk reduction strategies, they have not been widely implemented yet. The most popular risk reduction strategy utilized today is defensive equity, which 22% of respondents have implemented. Factor-based equity strategies and tail risk hedging are less commonly used, leveraged by just 9% and 5% of respondents, respectively.

Future expectations

Plan sponsors have significantly lowered their long-term return assumptions, according to the survey. Thirty-four percent of respondents have a return assumption of 6% or less compared to 20% in 2017. The percentage of plan sponsors with a return assumption of 7.5% or more has declined. Just two years ago, 33% of respondents expected that level of returns. In 2019, 21% did.

An increased number of plans are unsure if they will stay open (23% vs. 12% two years ago), potentially due to growing costs and interest rate volatility. Consistent with prior years, about 15% are planning a full plan termination, and 35% of state it may occur over the next five to seven years.

Twenty-two percent considered but rejected a plan termination, and 78% cite costs to purchase an annuity as the reason. There was a small increase to those planning or implementing hibernation strategies in 2019 (20%) compared to 2017 (11%). 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.

Lump sums remain the most popular liability risk reduction strategy, eclipsing plan terminations and annuities. Eighty percent of respondents have already implemented (54%), or plan to offer (26%) lump sums. Of the 26% that plan to offer lump sums, 67% plan to offer them to retirees due to the IRS guideline change.