Pension Investment De-Risking Primer

As a layer of protection, pension plan sponsors should carefully monitor how they de-risk their plan’s assets when they allocate investments, or how they de-risk its liabilities when allowing for a lump-sum window or annuity purchases.

After the financial collapse beginning in 2008, the funded ratio of most plans severely declined. However, after an extended bull-market and required contributions mandated by the Pension Protection Act of 2006, the funded ratio for most of these plans improved significantly. Plan sponsors should now be looking at ways to minimize the risks to the funded ratio, which can deteriorate quickly if discount rates or equity markets decline. An effective way to protect against these declines is through a strategic use of liability-driven investing (LDI) and a dynamic investment policy that minimizes both discount rate risk and equity risk.

An LDI approach involves using long-duration fixed-income instruments that match the duration of the plan liabilities. Duration is a measure of interest rate sensitivity for both plan liabilities and fixed-income assets. For a plan that has fully implemented an LDI approach, if discount rates decrease, resulting in higher present value of liabilities, the assets will also increase, resulting in little impact in the overall funded ratio of the plan.

Many plan de-risking strategies also involve a dynamic investment policy to specifically address when changes to the overall asset allocation are to be made. A dynamic glide path provides for specific and predetermined allocation changes by increasing exposure to LDI markets and decreasing exposure to equity markets. These predetermined changes typically occur based on an increase in the plan’s funded ratio. This approach locks in funded ratio gains as they occur and limits significant increases and decreases in the funded ratio as more assets are shifted into LDI allocations.

The graph below shows a sample dynamic investment policy. The funded ratio is typically calculated using market value of assets and a market value of liabilities.

• At a funded ratio of 60% or below, 60% of the overall portfolio is invested in equity or “risky” assets, with the remaining 40% invested in LDI.
• The dynamic investment policy will define specific thresholds—usually increases of 5% in overall funded ratio—at which point a greater percentage of assets will move to the LDI portion of the portfolio while decreasing the percentage of the risky portfolio.
• Monitoring the plan’s funded ratio is critical and should be done regularly—at a minimum quarterly)—as well as after large cash flow events and after any significant market events.

Plan sponsors should be prepared to address market conditions that result in a decrease in the funded ratio. At this point, the approach could be to “re-risk” the allocation, resulting in an increase in risky assets until the funded ratio is improved.

Taking an integrated approach to managing your plan’s assets and liabilities best protects the funded status. LDI solutions and a dynamic investment policy can together be an effective means to limit significant changes in the overall funded ratio of the plan.

Sterling Price, a managing consultant at Findley, has over 20 years of actuarial and consulting experience related to the design, funding, administration, and regulatory compliance of retirement plans. He has experience with both qualified and nonqualified retirement plans. Sterling has worked with a wide range of clients including governmental entities, church groups, and private employers.