Smart strategies to reduce pension plan risk

With healthy funding levels, pension plan sponsors have a unique opportunity—and more options—to de-risk their plans.

These days, the state of pensions is strong. The average U.S. corporate defined benefit pension plan is fully funded on an accounting basis. “Since the global financial crisis, the health of the average pension plan has never been better,” says Owais Rana, managing director and head of liability-driven investing at Principal Global Investors^®.

How did they get here? One answer is the sustained bull market that drove equity markets to record heights in recent years. Another, more significant, answer is the unprecedented rise in the long-dated corporate yield curve over the past 12 months, which has substantially reduced the accounting liability values. As these two markets moved favorably for a pension balance sheet, the average plan’s funded status improved markedly, boosting the ability to meet future obligations.

Now, with the stock market’s uneven 2022 performance in mind, plan sponsors may want to consider a more timely question: What’s next? Rana notes that healthy funding levels are leading many corporate pension plans to reevaluate their de-risking options, including hibernating investment strategies as well as pension risk transfer options. “It’s a Goldilocks moment for pension plans to de-risk and lock in their healthy fundedness quite substantially, and buy exposure to assets that are going to behave more like the liabilities they have on their balance sheet,” Rana says.

Pension Surplus/Deficit
Milliman 100 Pension Funding Index, USD bn,  2000 - 2022

The benefits of de-risking

Pension plans typically maintain exposure to a variety of diversified assets, from Treasury bonds and investment-grade credit to equities. In recent years, Rana says, the average pension plan has allocated roughly 50% of its assets to growth assets such as equities. That exposure makes these plans vulnerable to stock market swings. The most straightforward way to address that risk is to shift toward more conservative investments such as bonds.

Selling growth assets and buying long-dated fixed income assets can reduce funded status volatility, which in turn can keep companies from having to divert more of their financial resources to shore up their pension plans. After all, funded status deficits typically increase when equity markets fall. In these situations, corporate plan sponsors may need to direct excess cash to cover a potential deficit.

On the liability side, interest rate risk and credit risk can be managed through careful selection of fixed income investments that closely match the plan’s liabilities. For instance, a plan might create a range of fixed income holdings with different durations aligned with the expected future benefit payments, various employee demographics and timelines.

De-risking also carries the benefit of giving a plan more latitude to take advantage of a pension risk transfer, in which the plan moves risk away from the company through the purchase of a group annuity or another insurance product. By locking in their funded status, a plan sponsor minimizes the impact of volatile market conditions.

In most cases, pension plans have caps on the upside of their funded status. Rana notes that when pensions are overfunded, companies can get hit with an onerous excise tax if they want to pull that surplus money out of the plan. “There’s a considerable risk in being overfunded,” he says.

Indeed, in these situations, there’s little value in taking asset-liability risk when a plan becomes overfunded beyond a certain level. Additionally, relative size of the pension plan to its sponsor is also a key driver in employing a robust de-risking framework. “For companies whose pension plans are a multiple of the size of the sponsor’s balance sheet, pension risk management becomes very, very important,” Rana says.

A more customized approach

For corporate pension fund sponsors, de-risking may appear to be as easy as swapping equity exposure for off-the-shelf fixed income investments such as long-dated Treasurys or corporate bonds. However, Rana says a plan sponsor needs to carefully consider its allocation of incremental assets within the liability-hedging portfolio. As the hedging portfolio builds up, its efficacy will be enhanced by adding exposures to different maturity profiles of the credit market that reflect the liability profile of the plan. This level of customization becomes important when the hedging portfolio becomes a significant portion of the plan’s overall asset allocation.

Rana notes that smaller plans can also benefit from these types of sophisticated de-risking structures. The plans can gain access to more customized solutions through specially designed investment-pooled vehicles providing exposures to different maturity profiles of the corporate bond market. In essence, a small plan can buy units in these pooled vehicles as building blocks to create a duration profile that more closely matches its liability profile.

A traditional hedging strategy for pension plan sponsors to manage interest rate and credit spread risk is to purchase publicly traded long-duration corporate bonds. But while that strategy might help reduce the first-order interest rate and credit spread risk relative to liabilities, it may also result in a more concentrated portfolio as plans continue to de-risk and add more of the same types of issuers in their portfolios.

Another option is to consider alternative credit strategies such as private, investment-grade credits or commercial mortgage loans (CMLs). These assets can help provide diversification and also potentially generate higher yields without taking on additional risk. “By diversifying your credit spread exposure, you’re enhancing the efficiency of your liability-hedging portfolio,” Rana says.

The stock market’s steady gains and a recent increase in the bond yield curve have put sponsors in an enviable position. But what these fully funded plans should do now is take full advantage of that position. That includes more customization to shape the portfolio to look like its liabilities as well as looking beyond traditional fixed income investments by evaluating a broader universe of investment options to enhance liability-hedging efficiency. “The time is right to solve these problems in a more meaningful manner,” Rana says.