To manage risk in their pensions, an increasing number of plan sponsors have adopted glidepath de-risking strategies that shift assets out of equity-like investments into liability hedging fixed income as the plan’s funded status improves.
While most plan sponsors understand the benefit of controlling a pension plan’s financial risk by adopting these strategies, some have hesitated to make allocation shifts because of the perceived impact on the company’s earnings.
Here we summarize some of the benefits of de-risking on a glidepath and illustrate that the impact on net income could actually be minimal or positive.
Glidepath strategies for pensions typically have high allocations to high returning but volatile equity-like investments at lower funded levels to help drive asset growth. These strategies shift a portion of those assets into fixed income investments that are highly correlated with plan liabilities as the funded status improves.
By adopting a glidepath, the plan sponsor can:
- Reduce the volatility of the plan’s funded status as the plan de-risks, which translates to less volatile contributions as well as balance sheet and administrative costs, such as Pension Benefit Guaranty Corporation (PBGC) premiums
- still earn potential excess returns at low funding levels to help close the funding gap due to the gradual nature of the de-risking (that is, higher equity allocations maintained until funding levels improve)
- minimize potential trapped surplus for frozen plans, which results when the plan has excess assets that cannot be pulled out of the plan dollar for dollar at termination
- build market timing decisions into the investment strategy by using market-sensitive funded status triggers versus using a plan sponsor’s judgment to time asset allocation changes.
Generally speaking, equity-like investments have higher projected returns than fixed income investments. By adopting a glidepath, future expected returns for the portfolio are expected to decline when funded status improves as part of the de-risking process. A reduction in expected return on assets (EROA), which gets used in the pension expense calculation, could mean higher pension expense or lower net income when considered in a vacuum. However, we recommend plan sponsors consider the path to de-risking plus the dollar impact (versus a reduction in EROA as a percent of plan assets) and the potential benefits from reducing funded status risk.
Table 1: Hypothetical Scenario
|Current State||Future State|
|1. Assets (millions)||80||100|
|2. Liabilities (millions)||100||100|
|3. Funded Ratio (1)/(2)||80%||100%|
|4. Equity Allocation||70%||30%|
|Expected Return Impact (5) x (1) (millions)||(5.2)||(5.0)|
Glidepath example above is hypothetical in nature and for illustrative purposes only. Results are based on the above‑stated assumptions. Actual results may vary significantly. Hypothetical results have inherent limitations because they are not based on actual transactions, but are based on various assumptions or past and future events, which can be influenced by hindsight.
To illustrate, consider the example displayed in Table 1 showing a plan that is 80% funded (current state) experiencing improvement in funding level that triggers de-risking (future state). Under this scenario, growth in the plan assets triggered de-risking the plan from 70% in equities to 30% in equities, which would indicate the EROA should be reduced from 6.5% to 5.0% for the new allocation. While the plan sponsor may have a negative view of the reduction in EROA, the increased asset base which led to de-risking mostly offset the impact of a reduction in EROA. The result is little change in the expected return component that reduces pension expense ($5.2 million benefit versus $5.0 million benefit). In addition, to keep things simple, the calculation does not consider reductions in expense that could be gained from a lower amortization of (gains)/losses, which would further improve earnings.
The example illustrates that de-risking does not necessarily hurt the company’s income statement, in particular if de-risking occurs after the plan has experienced improvement in funded status.
Also, many equity and credit analysts make adjustments to reported pension expense to back out EROA, which makes it less relevant.
Further, with recent changes to the presentation of pension expense implemented by the Financial Accounting Standards Board (moving most of the components of pension expense, like EROA, out of operating expense), the relevance of EROA has diminished, in particular for entities focused on operating margins. The EROA is even less relevant for U.S. entities that have adopted marked-to-market accounting or international companies governed by the International Accounting Standards Board.
For more information, contact Kimberlene Matthews, Director of Pension Solutions, at 312-338-8138 or email@example.com.