Throughout my career as an actuary, my defined benefit plan clients have always expressed that their biggest concern was the chance market volatility could adversely impact their ability to fund their pension plan obligations. This concern was reflected in our Pension Risk Study published earlier this year. According to the study, the overall burden of maintaining plan funding levels causes the most unease at 80 percent followed by the chance of investment losses having an adverse impact on the company’s bottom line at 77 percent.
What’s more, market volatility has broadened its range in 2020 with the stock market dropping over 30 percent, rebounding completely by August. Likewise, discount rates have been on a roller coaster ride with significant and historic decreases this year. In March, the daily treasury rates, which are listed on the US Treasury site, fluctuated by at least ten basis points ten times.
Given this environment, my clients are asking for support strategically managing the innate costs and risks associated with their pension plans now more than ever. Reflecting on these conversations, today I’d like to share how Asset/Liability Management (ALM) can help hedge pension plan risk.
Figure 1: Top sponsor concerns. Source: MassMutual Defined Benefits Plan Risk Survey 2020.
Implications of Pension Plan Status on ALM Strategy
We’ve all heard the expressions, “nothing ventured, nothing gained” and “no risk, no reward,” however, there is no benefit to an organization to taking risks that are not compensated with associated benefits. The objective is to weigh the risks and the potential offset strategies to calculate if the investment is a well-compensated risk.
For example, sponsoring an active pension plan means continued accrual of benefit obligations and many sponsors may take on some additional, yet calculated, investment risk with the intent of generating asset returns sufficient to cover the ultimate cost of the accruing liabilities. Because the plan is active, it would be offered to a broad employee base including new, and presumably younger, employees. With this younger employee base, there is a longer time horizon over which the plan’s investments can be invested — more time to wait out any market disruption and spread the risk over time.
On the other hand, a plan sponsor who maintains a frozen pension plan has less upside potential to gain from investment risk. With a frozen plan, there are no new entrants to the plan, so the time horizon for the plan’s investment portfolio shrinks as employees age. In this case, the risks associated with adverse effects of market disruption increase.
In addition, it’s important to note that there is no benefit to having a frozen plan that is overfunded on a plan termination basis. Plans with funding levels that surpass the amount needed to cover plan obligations after a plan termination are subject to onerous excise taxes. Whether aiming to terminate the plan soon or not, there is limited benefit to taking additional investment risk when managing the plan assets of frozen plans. In short, many frozen plans would benefit from a more conservative investment approach and sponsors of such plans should consider managing the investment risks strategically and prudently.
In any case, implementing ALM reviews can help. Through periodic ALM reviews, plan sponsors and their investment advisors can gain a better understanding of the state of their plan’s financials and establish clear goals. More specifically, the plan sponsor gains better insights about the plan’s assets in relation to the plan’s liabilities. The ALM review arms plan sponsors and their investment advisors with key information that can help them choose investments that are appropriate given the pension plan’s liability characteristics.
Implementing a Glide Path Strategy
At the most rudimentary level, an ALM approach recommends reducing the plan’s equity exposure as the plan’s funded status nears a fully funded state and replacing the equity investments with fixed income securities that have a duration that aligns with the plan’s liabilities. One simple ALM tool is the use of a glide path strategy (figure 2), in which the asset allocation is based on one or more variables, such as the plan’s funded status.
Figure 2: Traditional Glide Path Strategy. Source: MassMutual.
Aligning the asset and liability duration helps reduce the risk due to changing interest rates. If interest rates decrease, the pension liabilities grow. But assets invested in fixed income securities of a similar duration as the liabilities will grow in tandem.
As we mention aligning plan assets to plan liabilities, it’s important to mention LDI, and the difference between ALM and LDI. As you may know, LDI refers to Liability Driven Investing. While the strategic management concepts discussed during ALM conversations and LDI conversations sound very similar, the difference is the context. LDI is a very specific investment strategy where as ALM is the broad oversight and strategic management of pension investing. For more information on the benefits of an LDI strategy, please refer to our post, “Is your pension plan prepared for unexpected market events?” by Karen R. McColl, CFA, Head of Defined Benefit Plan Services.
As a final point, it’s also very important to consider market interest rate trends when evaluating plan pension plan financials and investment strategy. To that end, market updates, such as the MassMutual Quarterly DB Market Commentary, can be invaluable resources.
The Right Partner Can Make All The Difference
Here at MassMutual, our team of actuarial consultants are available to provide expert support and guidance to help sponsors and their financial intermediaries strategically manage their pension plan and the investments. We’d appreciate the opportunity to discuss ways we can help achieve plan sponsor goals with you. To learn more, please contact us today at DBSales@MassMutual.com or 1-800-874-2502, option #4.