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.