Investing June 8, 2016

Now Is Not the Time for De-Risking DBs

Market volatility and funding relief allowing lower required contributions have impacted the value of LDI and other pension plan de-risking strategies, SEI says.
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“We’ve been big proponents of derisking [pension plans], such as using LDI strategies that reduce risk as funded status rises,” says Tom Harvey, director of the Advisory Team within SEI’s Institutional group in Oaks, Pennsylvania.

However, he tells PLANSPONSOR that, depending on plan size, now is not the time for most defined benefit (DB) plan sponsors to de-risk or annuitize their plans.

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In a Q&A on SEI’s website, Harvey explains that “the goal of de-risking strategies is to minimize volatility between the investment asset pool and the pension liabilities, based on how pension liabilities are calculated for accounting and funding purposes. Reducing the swing between these two measures creates more certainty for both the projected funding gap and required contributions. Currently, these two measures—generally accepted accounting principles (GAAP) and Employee Retirement Income Security Act (ERISA) funding—have diverged. This has created an environment for most plan sponsors where surplus volatility against the liability doesn’t trigger additional contributions, thus reducing the value of the LDI strategy.”

Add to that new funding relief that lowers required contributions for DB plans, and Harvey says DB plans’ funding status is going down. “If plan sponsors haven’t been using LDI aggressively in the past, now is not time to do that or to annuitize because now they will have to pay an insurer more to move assets,” he says.

NEXT: Pursue greater returns

According to the Q&A, the current environment “allows plan sponsors pursuing return-oriented strategies to continue those strategies without the near-term potential of being required to make funding contributions.” Harvey tells PLANSPONSOR DB plan sponsors need to think more about other assets classes they may have been skittish about. It is a necessity to evaluate whether they need to bring in more equity—private equity, long/short strategies, or international funds. “They need to prop up returns without increasing overall plan volatility,” he says.                       

“In the current environment, a plan sponsor pursuing an LDI strategy most likely needs to make supporting discretionary contributions to the plan—and forego the benefits of deferred funding. For most plan sponsors, that may not be optimal, as there’s likely a better use of their capital than pension plan contributions,” the Q&A says. However, Harvey notes that SEI is not suggesting all plan sponsors need to unwind their LDI strategies. It depends on the size of the plan, the size of the plan liability relative to market capitalization of the plan sponsor, as well as the plan sponsor’s specific risk management goals.

“Most plans should have a combination of a degree of funded status at which they can afford to de-risk and a normalized interest rate environment on corporate bonds. When they see these triggers, they can jump to annuitize,” Harvey concludes.
Investing June 8, 2016

Participant Demographics Key to TDF Selection

Morningstar Investment Management believes the first order of business for sponsors and their retirement plan advisers when selecting the appropriate glide path for their plan’s demographics is to determine the participant population’s “risk capacity."
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Defined contribution retirement plan sponsors are currently selecting target-date funds (TDFs) in a handful of ways, said Nathan Voris, director of sponsor and workplace solutions at Morningstar Investment Management, speaking during a webcast on “Optimal Glide Paths for Defined Contribution Plans.”

Typically, they rely on the proprietary series that their recordkeeper offers, Voris says. They also seek out the cheapest TDF series or try to find those with strong historical performance. “Fees are important but should not be the primary factor,” Voris says. “And because of the changing asset allocation in TDFs, it is hard to track their historical performance.”

Instead, he says, sponsors should focus on four “layers of methodology,” in this order. “First, glide path design, followed by asset class exposure to ensure it is appropriately diversified, including fixed income,” Voris says. Next, “the asset allocation methodology and how the allocations in the glide path change over time. Lastly, whether it is active, passive or both. Because the latter is an easy conversation, many sponsors have moved that up to the front of the list, but it is our perspective that this should be the last order of business.”

Since the glide path is the most important factor when selecting a TDF, Morningstar Investment Management believes the first order of business for sponsors and their retirement plan advisers when selecting the appropriate glide path for their plan’s demographics is to determine the participant population’s “risk capacity,” says Lucian Marinescu, director of target date strategies. “A younger workforce has a higher level of ‘human capital,’ which is the value of future earnings, while an older population has a greater level of ‘financial capital,’” Marinescu says.

NEXT: The key participant dataIn order to determine this risk capacity, sponsors need to anonymously collect key data on each participant, namely: age, balance, salary, contribution and defined benefit (DB) plan (if applicable), Voris says. Then, sponsors can use Mornginstar’s Glide Path Selection Tool to generate individualized recommendations for each participant, says Daniel Bruns, manager, large market at Morningstar Investment Management. The tool shows the recommendations on a scatter plot that includes the trajectory of the average glide path for all of the participants. This is then overlayed with the glide paths for the three Morningstar Lifetime Indexes—aggressive, moderate and conservative—to determine which is the best fit, Bruns says.

Morningstar Investment Management then illustrated four case studies. For a large manufacturing firm with lower than average salaries, average balances and slightly higher than average deferrals, the tool showed that the desired participant equity risk most closely aligns with the Morningstar Lifetime Moderate Index, Voris says. For a leading technology firm with higher than average salaries, balances and deferrals, the Morningstar Lifetime Aggressive Index is the best fit, Marinescu says.

The third case was a national retailer with lower than average salaries, balances and deferrals, for which the Morningstar Lifetime Conservative Index is the best fit, Bruns says. Finally, the fourth case was a large medical practice with a wide range of salaries between the administrative staff and the doctors. Although this plan’s workforce has above average salaries, balances and deferrals, because of the 25% dispersion, custom target-date funds or managed accounts would be the most appropriate choice, Voris says.

As Morningstar Investment Management notes in a white paper it recently issued, “The Glide Path Selection Problem,” “significant differences within products make the target-date decision perplexing for even the sophisticated investment committee. The most reliable method for assessing the risk capacity of a plan is to perform a quantitative analysis of the plan’s participants, to determine the risk capacity, or appropriate equity exposure, of a specific plan. With so many assets flowing into target-date funds, it is imperative that plan sponsors diligently select the glide path most appropriate for their participants.”

The Morningstar Investment Management white paper can be downloaded here.

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