Over the last decade, corporate pension plan sponsors have increasingly adopted glidepath investment strategies that seek to reduce downside funded status risk that affects contribution requirements and the balance sheet.
A glidepath strategy has a higher allocation to equity and equity-like assets at lower funded levels and is more allocated to fixed income assets that behave like the liability as the funded status improves.
With recent volatility observed in interest rate and equity markets, a common question from plan sponsors adopting new strategies is: “What happens if funded status falls?” While the answer is dependent on individual situations, we will share some current best practices for re-risking.
Plans that adopt glidepaths are in practice preapproving future allocations changes based on changes in funded status. For example, if the funded status increases from 92% to 96%, return-seeking assets (that aim to outperform liabilities) are reduced from 40% to 30%. Under this scenario, more assets would be invested in liability hedging assets that aim to reduce volatility of funded status. The re-risking decision is presented if funded status were to then fall back from 96% to 94% — should the allocation revert back to 40% return seeking?
To Re-risk or Not to Re-risk
There is no one-size-fits-all approach to making this decision.
Re-risking can be valuable in certain situations. Though the actual gain or loss from re-risking is uncertain at the time of the decision due to uncertainty in future markets, the following best practices could help to improve potential outcomes:
- The most important thing to consider in the decision is the plan sponsor’s desire and ability to take on additional risk. Some plan sponsors are committed to de-risking only, which is a reasonable choice for plans looking to minimize volatility of funded status. Factors such as corporate philosophy, pension size relative to company, or contribution policy typically come into play when deciding to de-risk only.
- Re-risking generally provides the most benefit for plans that are open or ongoing, since additional equity returns can help offset future benefit accruals. For frozen plans, there could be a tradeoff presented, with time horizon coming into play as well. Plans with longer time horizon have more time to recover from potential losses.
Immediate re-risking based on small drops in funded status is usually not effective due to potential excessive trading.
- As such, in the example of a drop from 96% to 94%, immediate re-risking is not preferred since such small changes can be expected frequently. For plans that allow re-risking, best practice is to re-risk at a slower pace — for example, requiring the funded status to fall two stages on the glidepath before re-risking (in current example, fall from 96% to 90%).
- For plans that are relatively overweight traditional equity investments in their return-seeking allocations, it is possible to use re-risking as a way to add alternative asset classes (such as real estate or credit strategies) instead of adding more equity. This could provide excess returns above the liability while improving the risk profile relative to traditional equity.
- If the plan sees a drop in funded status due to nonmarket factors such as demographic changes, actuarial assumption update, or changes to the plan structure, it is best to re-evaluate the glidepath versus following the normal procedures adopted for the glidepath.
- Formal adoption of the glidepath strategy, rebalancing, and re-risking policies into the investment policy statement usually provides the best execution in uncertain market environments. This removes last minute decisions that could be costly for the pension plan if markets go in the wrong direction.
Re-risking should be considered carefully with your investment advisor to understand how the asset allocation will change the financial risk of the pension plan.
Both equity and interest rate risks are significant for pension plans and should be reviewed when making investment decisions for the pension. Whether the plan sponsor decides to allow re-risking or not, daily review of funded status is the preferred approach to managing glidepath strategies. This allows investments to be shifted as soon as the market provides signals.