As defined benefit pension plans mature, we believe keeping on track towards a long-term target is increasingly important
Most private sector defined benefit (DB) pension plans have closed to new members, with many also closing future accruals for existing members. Whilst liabilities may extend well into the future, that time horizon is steadily shrinking. The focus has therefore shifted from short-term funding issues and service cost management towards identifying a long-term endgame.
The challenge for pension providers lies both in agreeing what that long-term goal should be, and in devising and implementing a journey plan, whilst ensuring that member benefits are paid on time and in full.
Developing and sticking with a long-term funding strategy comes with many challenges, from volatility in global investment markets and sponsor covenant risk, to non-financial factors such as regulatory impact and member life expectancy.
In some instances, it may involve uncertainty as to the benefits eventually paid, in particular where plans have discretionary elements, benefit indexation or are subject to regulatory uncertainty. However, recent years have also seen significant growth in understanding of, and potential solutions to, those challenges.
Defining your defined benefit pension end-game
For DB pension trustees, the core objective is seeking to secure the full and timely delivery of members’ benefits. Plan sponsors naturally have other, additional priorities, but it is in both parties’ interests to work constructively to achieve an agreed endgame, and regulatory encouragement towards such agreement is increasingly evident.
For most, this means either gradual run-off of the scheme’s investments or the transfer of risk – either to an insurance company or to members can use lump-sum transfers to finance their retirement in different ways.
A more recent development for some is consolidation – whether through combining the assets and liabilities of multiple plans within a sponsoring organisation, or across sponsors. In some cases, it may involve a combination of options, with a buy-in or buy-out transaction for part of the plan’s membership, while the remainder moves towards self-sufficiency and eventual run-off.
In agreeing the chosen outcome, a number of variables will need to be taken into account. The nature and timeframe of the agreed target will be influenced by a balance between affordable contributions and achievable investment returns, but will also be affected by other factors, such as risk appetite, sponsor covenant, or the cost and availability of bulk annuity or other potential de-risking solutions. Agreeing an endgame is a critical first step and will help determine the nature of the journey plan towards achieving it.
Implementing a long-term funding strategy
With a clear destination, risk appetite and timeframe established, all stakeholders have greater clarity on the road ahead. In our experience, the key to achieving the long-term goal is an investment strategy that balances contributions with investment returns while understanding and mitigating risk.
For maturing DB plans, risk is likely to reduce over time, but in an ordered and timely way. De-risking too early, for example, could extend the timeframe of the long-term strategy, increase pressure on the plan sponsor or require the trustee to adapt its asset allocation to more return-seeking options. De-risking too late, could involve the emergence of trapped surplus. To avoid being thrown off course, DB plans should consider several factors and options, including:
- Cash flow matching: potential solutions that enable plans to match benefit payments to high quality investments that distribute predictable income, including alternative forms of income such as private debt, thus avoiding forced selling of assets at times of market volatility
- Ensuring appropriate hedging of liability risk: if self-sufficiency is a long-term goal, a higher level of hedging may be necessary to mitigate the impact of adverse inflation, interest rate or life expectancy movements
- Aligning asset allocation with risk appetite: through continued reappraisal of the allocation between fixed income and growth investments, and diversification within the growth portfolio
A long-term funding plan might also consider matters such as how ESG1 objectives are embedded into the investment portfolio, the plan’s ability to benefit from returns on less liquid investments and ensuring an “insurer-friendly” portfolio if the endgame involves buy-out or the flexibility for opportunistic buy-out.
In navigating these complex issues, the plan’s governance model and use of limited internal resource is critical. We believe that it is important to find the right balance between insourcing and delegation across the investment process.
Throughout the journey, proactive monitoring and regular reporting are vital in supporting the governance process. Effective oversight can help to ensure that decision making is informed by market and price transparency and that even fleeting opportunities are captured in often volatile investment and insurance markets.
Coordination and alignment
Implementation of any individual measure can only be considered fully successful if it is coordinated within a holistic long-term strategy. Cash-out options or buy-outs for retirees, though constructive ways of reducing liability risk, are most effective only if considered in light of their impact on the plan’s wider investment strategy, for example.
The journey towards the endgame is best travelled when all the constituent parts are considered holistically. This involves careful sequencing and coordination across asset and liability management, as well as consideration of impacts on plan members, sponsor covenant and resource planning. It is a continuous process, requiring effective governance, monitoring and reporting.
Implementing an effective long-term funding strategy aimed at achieving an agreed endgame can be a complex process, with numerous challenges and variables. But for most DB pension plans, as they mature, it is not just a “nice to have,” but an essential.
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