As the pension landscape continues to get more complex, with volatile markets, potential changes in Fed policy, pension funding relief, and new mortality tables, Mercer’s defined benefit plan experts have identified five steps that plan sponsors can take to improve their funded position and manage pension risk in 2015.
1. RE-EVALUATE THE PLAN’S GLIDE PATH
For many years Mercer has advised on the need for plan sponsors to incorporate risk management triggers, which could be based on funded status, interest rates, or other factors, to lock in funded status improvements as they arise. Many sponsors have implemented these glidepath strategies and for the most part those strategies have worked well, allowing sponsors to take risk off the table as funded status improved. With numerous changes in the pension and economic environment, now is a good time for plan sponsors to take a fresh look at their glide paths and ensure that they continue to be effective.
The recent publication of new mortality tables by the Society of Actuaries (SOA) will increase reported liabilities for most plan sponsors by anywhere from 5% to 10%, with a corresponding reduction in reported funded status. Sponsors should verify that the allocation and funded status points along the glide path are still consistent with the new liability and end-state targets of the plan.
Given that market volatility is likely to continue in 2015, sponsors on a derisking glide path may need liquid assets available to effect asset allocation changes and policies in place to adjust promptly. Some plans may also be able to capitalize on volatility by using a more dynamic or market-aware derisking program. A dynamic approach might have a derisking plan that specifies risk or return targets as opposed to specific static asset allocations, which would allow the plan sponsor to identify the optimal portfolio as market conditions change. Using such a dynamic risk management process requires enhanced portfolio monitoring, coupled with a nimble execution and governance process.
2. DEVELOP AN INTEREST RATE STRATEGY
Plan sponsors should have a strategy in place to deal with interest rate movements — good or bad. While 2015 might not feature systemic rises in rates, volatility could come into play as investors scrutinize the Fed’s announcements.
Prepare for the scenario in which rates remain low.
The plan’s funded status may determine the best way for sponsors to deal with these low rates. For a relatively well-funded plan, the sponsor may want to remove interest rate risk regardless of the rate level, either through increasing the hedge ratio or outright transfer of the risk through a cashout or buyout. For sponsors in a deficit position, moving to a high level of fixed income or extending duration may not be ideal. For some sponsors with good credit ratings, borrowing to fund may be a good strategy to access capital at low rates, and it could contribute to the growth side of the plan assets where higher returns can be earned.
Be ready to capitalize on rising rates as well.
An ability to quickly change the plan’s interest rate exposure or hedge ratio is essential for capturing funded status gains in the event that rates rise. This may require investing beyond cash bonds and considering investment instruments such as interest rate swaps and futures. Successful implementation of such a rising rate strategy will require close monitoring of interest rate and funded status levels, as well as coordination with or execution by the fixed income managers. Mercer has worked with many plan sponsors to serve as a “completion manager”, to help coordinate the overall management of the liability-matching portfolio.
3. REVIEW THE PLAN’S RISK-TRANSFER POLICY
Keep a watchful eye on annuity prices.
The large annuity deals in 2014 by Motorola and Bristol-Myers Squibb have caught the eye of many plan sponsors. Mercer anticipates a significant uptick in retiree annuity buyouts in 2015, especially for frozen plans looking to take a step toward downsizing the plan without moving to a full plan termination. Mercer’s Pension Buyout Index allows sponsors to monitor insurer annuity prices and estimate the potential cost of a buyout.
Align assets for annuity purchase.
Plan sponsors that intend to transfer risk to an insurer at a future date may want to invest assets to hedge against annuity price movements. This is an important technical area that should be carefully analyzed before moving ahead with any buyout deal.
Cashouts are still a viable strategy.
Although rates have declined since the beginning of 2014, a cashout program can still provide a sponsor the opportunity for significant savings from reduced PBGC premiums as well as administrative and investment costs associated with maintaining the assets and liabilities in the plan. The SOA mortality changes will likely not be effective until 2017 for Internal Revenue Service lump-sum calculation purposes, so sponsors still have a cashout opportunity in 2015 to potentially reduce plan risk and costs.
4. REVIEW THE PLAN CONTRIBUTION POLICY
The Highway and Transportation Funding Act of 2014 (HATFA) gives many sponsors more funding flexibility, with reduced minimum required contributions for the next few years. However in most cases HATFA is in effect only a delay of funding requirements, and most sponsors will eventually contribute a similar total amount to the plan whether they fund the minimum allowed or contribute at a steady pace.
Sponsors should consider whether they have greater flexibility now to contribute and gain tax deductions or, instead, they prefer to allow that opportunity to pass and await mandatory contributions. In addition, discretionary funding above HATFA minimums has the benefit of potentially reducing PBGC premiums and reported pension expense.
5. REVIEW THE INVESTMENT PORTFOLIO
In a market environment characterized by low interest rates and low return expectations, sponsors should ensure that they are managing their investments in the most effective manner possible.
Sponsors of well-funded plans should assess investment risk.
For those well-funded plans that are not terminating but are running in a low-risk “hibernation” state, some critical portfolio construction issues should be considered. A hibernation portfolio is more complex than merely holding a portfolio of long bonds. Some of the key issues to consider are the amount of growth assets required to maintain funded status and the balance between Treasury and credit bonds. Full details are contained in our new white paper on the subject.
Consider a ‘buy and hold’ credit portfolio.
Building a fixed income portfolio that can keep up with liability values is challenging, particularly because liabilities don’t suffer from downgrades or defaults, while bonds can lose value due to downgrades and defaults. Traditional passive corporate bond portfolios are perhaps the least-effective approach to gaining corporate bond exposure since they mechanically sell downgraded bonds that have fallen in price and buy upgraded bonds that have risen. Mercer’s research indicates that although active long-duration may add value versus a benchmark, the value added net of fees may be marginal. An alternative approach to gaining corporate bond exposure that is consistent with plan liabilities is to build a portfolio of high-grade bonds with the intent to hold them until maturity. The additional benefits are that the portfolio can be constructed to be consistent with the plan’s expected benefit payments, so it becomes a liability-matched passive portfolio. This approach does still require oversight to monitor the bonds for significant downgrades or corporate events, but this can be done in a very cost-effective manner.
Step back and focus on strategy and make sure assets are managed in the most effective manner possible in the current environment.
With fairly valued equity markets, avoid the qualities that tend to lead to weaker performance over the long term, including high volatility holdings, an expensive portfolio on valuation measures, low quality holdings, high levels of portfolio turnover and high fees. In fixed income, with a benign outlook, low rates and low liquidity, be aware of the risks of stretching for yield and sacrificing liquidity. In alternatives and hedge funds, an assessment of cost versus value-added is always timely to ensure you are not paying too much for short term diversification. Also, given fair valuations, plan sponsors should ensure their hedge fund program is not driven by equity beta or leveraged interest rate exposure. Finally, at the total portfolio level, use market volatility to your advantage by rebalancing to asset allocation targets, which will increase returns and lower risk in the long term.
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