Both our for profit and tax exempt sector clients have sought our perspective when developing their assets allocations. Reducing the volatility associated with defined benefit pension plans requires the consideration of the complete program and its various components: plan design, annual funding goals and investment strategy. Many clients, especially those with frozen benefits and fully funded programs are motivated to limit any threat to their funded status. Plan sponsors can use several techniques to “protect” plans against erosion in their funded status. In assessing the value of investment techniques such as the LDI approach described below, we have helped clients take into consideration the whole effect upon their balance sheets, and have separately identified the differences for tax-exempt and for profit employers.
Dynamic ALM forecast valuations (asset liability models) are useful in revealing the effects modifications in each of these aspects may have upon the funding of the Plan. There are a variety of techniques currently employed to address volatility issues. Investment techniques include adjusting asset allocations to contain “duration matched” fixed income investments (Liability Driven Investments – LDI) which synchronize the movement of the bond portfolio held by the Plan with the benefit liability when measured on a current bond yield curve.
There is usually a “cost” associated with an LDI approach in that the expected total return on investments is lower than that which would be expected if the Plan had a diversified portfolio which had allocations of equity and other risk related assets. The LDI approach may lower the overall expected return on assets depending on market conditions. The LDI approach becomes more attractive for “frozen” plans where additional benefits are no longer being accrued, or for plans that are very well funded and wish to protect their current funded status, and for those sponsors less concerned about increased future contributions. Many Plan sponsors choose to devote a portion of their portfolio to bonds on an LDI basis to hedge some of the interest rate risk and add stability to the funded ratio. In this way with a combined LDI/diversified portfolio, sponsors still achieve the additional returns associated with equity investments.
Solution : Tax Exempt Sponsor: Fully Funded Plan
Our tax exempt client sponsors a fully funded frozen pension plan with a significant surplus, and had at the recommendation of the investment advisor, been pursuing a total LDI investment approach. This approach protected the “funded status” of the plan in that the funding ratio would not deteriorate with changes in interest rates, however it subjected the funding surplus dollar value of the plan to significant erosion in an increasing interest rate environment, without any benefit to the plan. Since the surplus of a tax exempt employer is not subject to the 50% excise tax or income tax, retaining surplus amounts can have significant value to tax exempt employers. MWM actuaries illustrated to the investment advisor and the plan sponsor, the leveraged sensitivity of the surplus to changes in the interest rate under the total LDI approach and suggested that perhaps a significant portion of the surplus be invested in shorter duration bonds, or a more diversified asset mix. The investment advisor agreed and the surplus was invested in a mix of shorter duration bonds and some equity asset classes to protect the dollar value of the surplus, and the remaining portfolio which fully covered the plan liabilities was continued under a fully LDI matched approach.
Solution : For Profit Sponsors : Gradual Implementation with Full LDI at Full Funding
It is important to appreciate that the tax status of the plan sponsor, as well as the plan funded status, is a very critical factor in determining whether an LDI approach is advantageous since the risk/reward ratio changes. For profit sponsors are taxed at 80% on reversions from qualified plans. This means that a for profit employer will receive only 20 cents on the dollar for any excess assets which could be returned upon termination of a plan, but will have to pay 100 cents on the dollar for every dollar of underfunding. This relationship skews the normal risk / return tradeoff in favor of a very cautious investment portfolio once full funded status is achieved. It is also the reason why many for profit sponsors of frozen fully funded pension plans have elected to forego additional returns associated with equity allocations, in favor of a wholly LDI matched portfolio. However until the plan is fully funded, or if the plan is still accruing benefits, the risk/return proposition for asset allocation for a taxable employer is not skewed.
We have illustrated to tax exempt clients, and to taxable clients with unfunded benefits, that there is a cost of implementing a totally LDI investment approach, especially at low interest rates, in the amount of additional required contributions that will be expected. The stability associated with a total LDI approach, also precludes the anticipation of increased investment income being available to fund accrued and/or future benefits.
For our taxable clients with unfunded benefits in a frozen plan, we collaborated with the investment advisors to develop a partial LDI approach, where the LDI component increased as the funding ratio of the plan approached full funding.