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Small defined benefit plans can't manage risks while standing still

Asset-liability management for defined benefit plans involves a careful balance of conflicting objectives.

On one side, the 30-year US Treasury yield is currently at 2.9 percent, and pension plan return assumptions are around 7.0 percent; clearly, plans need to invest in higher-risk assets to be able to generate sufficient returns to cover their pension obligations.1 On the other side, plans want to reduce funded status volatility and mitigate interest rate risk; these objectives favor investing in more conservative assets. Thus, a plan’s asset allocation strategy plays a crucial role in the plan’s long-term financial stability, and the overall progression of its funded status through time.

Securian AM believes that small plans—ones with assets of $200 million or less—often do not receive the same level of asset management sophistication as their larger brethren. In our view, they receive a “set it and forget it” asset allocation, perhaps with an annual check-in, which can be problematic, but there are potential solutions

Duration mismatch

In our opinion, the largest problem with not having a customized pension plan asset allocation lies in the interest rate sensitivity of the plan’s liability.

As interest rates move, they affect the present value of the liability, even if there are no new participants or changes to compensation. If a company has a pension plan with only participants who are retired and collecting monthly payments, our analysis finds that the duration of this liability is probably around nine years. If a pension plan also has active participants who have not yet retired, our analysis shows that this duration can be 15 years or more. The duration of many core bond funds is in the four to six year range, in our estimation.

What does this all mean in terms of asset and liability values through changes in interest rates?

Defined benefit plan table

Source: Securian Asset Management

The plan’s assets could be more tailored for the liability than simply using an index-tracking core bond strategy. Further, going to longer duration assets typically has the added benefit of improving the portfolio yield.

Risk exposure is magnified for small plans

Among underfunded plans, the average plan size generally gets smaller as funded status gets worse.

Fuding ratio (%) Average plan liability ($M)
Less than 40 156.9
40-49 6.4
50-59 36.1
60-69 89.4
70-79 204.4
80-89 297.7
90-99 289.8

As the table above shows, the average plan size decreases steadily as funded status goes from about 90 % to 40 %. Consequently, many smaller plans carry a higher equity exposure in hopes of having their assets “catch up” to the liability.

However, in our opinion this scenario increases their risk exposure by exacerbating the interest rate mismatch already discussed, and it increases the plan’s equity drawdown risk. A typical plan that is 80% funded and carrying an equity allocation of 50% needs to understand that an equity market scenario similar to 2008 could cut its funded status by 20% or more.2 Such a plan should be asking whether or not that much equity risk is appropriate, and if there are any risk management techniques that should be integrated into the portfolio. There are managed volatility, equity tail risk hedging, or portfolio overlay strategies that may be appropriate, especially in light of a plan’s particular business circumstances.

Asset allocation that does not evolve

We find that most pension plan portfolios are comprised of a diversified mix of assets: Treasurys, corporate bonds, domestic and international equity, inflation-hedge assets (e.g. TIPs or commodities), and potentially a slew of other choices like structured products, private credit, hedge fund exposure, etc. Unfortunately, it appears that smaller defined benefit plans often have a static allocation to these assets.

For some time now, larger plans have had access to liability-driven investing (LDI), under which the plan’s asset mix changes with its funded status. In simplified terms, as funded status improves, the allocation to growth assets (e.g. equities) is reduced and shifted to a mix of fixed income securities that provides the desired interest rate hedge for the liability. In our opinion, when the plan reaches fully funded status, the asset mix should be predominantly Treasurys and corporate bonds.

In this case, the values of the assets and liability for a plan will remain close to the same regardless of which direction interest rates move. Obviously an LDI mandate takes more monitoring and effort for both the asset manager and plan sponsor, but the benefit is that the plan more effectively locks in funded status gains when growth assets do well, and more smoothly progresses toward being fully funded.

Assembling the pieces

Small plans can reap the same benefits as larger plans from an LDI strategy, and should be considering asset managers with the ability to provide this type of collaborative, engaged investment oversight in the small plan space.

Specifically, asset managers should be able to do the following for clients:

  • Provide customized LDI solutions to smaller plans that address their specific goals, whether it is to reduce interest rate risk exposure, minimize funded status volatility, or become fully funded over time.
  • Offer each client a true duration-matched and diversified fixed income portfolio, tailored to its liability. This product may even be possible for plans with assets in the $5 – $10 million range.
  • Employ a managed volatility strategy within a plan’s growth assets to produce equity-like returns with reduced drawdown risk. This strategy may translate to lower funded status volatility, even for plans that are relatively underfunded and thus carry higher growth asset allocations.
  • Manage each client’s assets according to an LDI glide path that helps to lock in funded status improvement as it occurs.

About Securian Asset Management, Inc.

Securian Asset Management, Inc. based in St. Paul, MN, is an institutional asset manager specializing in public and private fixed income, commercial real estate debt and equity, pension solutions and alternative investments strategies with more than $38 billion under management as of December 31, 2018. The asset manager was established in 1984 and traces its history to the founding of parent firm Securian Financial Group in 1880. 

Sources: Securian Asset Management, Inc.

1. NASRA Issue Brief: Public Pension Plan Investment Return Assumptions, updated February 2019. Bloomberg
2. Willis Towers Watson's 2017 asset allocations in Fortune 1000 pension plans

The opinions expressed herein represent the current, good faith views of the author at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/ or obtained from sources believed to be reliable; however, Securian does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained in this article are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and Securian assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change.

This material may not be reproduced or distributed without the express written permission of Securian Asset Management, Inc.

Securian Asset Management, Inc. is a subsidiary of Securian Financial Group, Inc.


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