DB Investing Strategies to Consider in 2016

Advisers may want to recommend defined benefit plan sponsors pursue more active strategies and different asset classes.

In the past couple of years, a big focus for defined benefit (DB) plan sponsors has been the interest rate environment. Rising interest rates may be a reality for 2016, says Michael A. Moran, senior pension strategist at Goldman Sachs Asset Management (GSAM) in New York City.

Jeff Coons, president of Manning & Napier in Rochester, New York, agrees: “We’ve been talking a long time about what happens when the bond market gets more volatile. We will now see plan sponsors forced to address it.”

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Since DB plans have a natural time horizon and duration of liabilities, fixed-income investing is to some extent in bonds, but plan sponsors must consider asset return assumptions, and a rising rate environment can be a drag on absolute returns, according to Coons. “We’ve bee talking about what can happen for a few years, but translating it into mandates for portfolios hasn’t occurred. With bond market risk more front and center, plan sponsors will have to address allocations to fixed income.”

The benefit of long-duration bonds in a falling rate environment is important to keep up with liabilities, but it will turn the other way with rising rates, Coons says. He contends there will be more focus on a Barclays-type benchmark. “We will see more active mandates and nontraditional and unconstrained bonds. As an analogy, over time equity allocations have moved from hiring managers whose performance looked a lot like their benchmarks and turned out little value to managers performing above their benchmarks. The same trend will happen with bond allocations,” he tells PLANSPONSOR.

Moran says preparing for a higher rate environment will be a catalyst for a shift to more fixed income. GSAM is seeing continued interest in unconstrained fixed-income strategies that give managers more room to address duration. In addition, they are adding one or two more fixed-income managers to their portfolios to increase fixed-income holdings from, for example, 40% today to 50% next year and 60% thereafter.

NEXT: Need for more returns

With rising rates, it will probably be a tougher return environment in the next couple of years, Moran says. For many plans, this is a risk management exercise; he notes that on an aggregate basis, DB plans are about 83% funded, same as last year, so plan sponsors need return. Plan sponsors should look to shifting equity exposure to protect from downside risk; hedging and smart beta strategies are being used.

Many corporate and public DB plans have reduced their long-term return assumptions, but it may still be a challenge to hit those, Moran predicts. He says passive management has worked for corporate plans the past couple of years, but now they need active management, or to use asset classes such as real estate, private equity or emerging market debt.

Public plans, in general, have always been more return-focused than corporate plans, as more corporate plans are closed or frozen, Moran notes. With a longer term time horizon, and many public plans not well funded, as well as the expectation of a more muted return environment, GSAM has seen them expand their use of alternative investments

With the divergence of performance in the developing world, Coons expects plan sponsors will rebalance their portfolios to take advantage of what is growing. He notes that before and shortly after the credit crisis, there was a big push to make emerging markets a larger percentage of DB plan holdings, since that was where growth was expected to be. However, since 2011 and 2012 emerging markets have shown a dramatic underperformance, and now there are lower allocations to emerging markets across the pension universe.

“My guess is that there will be a need to rebalance to bring back some of these allocations, but the focus will be on more active mandates,” he says. Coons also notes that growth is coming from the consumer and sciences sectors, so it’s likely mandates will take advantage of emerging markets and consumer-oriented growth.

NEXT: Risk transfer prompts changes in portfolios

Changes in the regulatory environment—funding relief and higher Pension Benefit Guaranty Corporation (PBGC) premiums—are enhancing risk transfer activity, either lump-sum offerings or annuitization, Moran tells PLANSPONSOR. Investment strategies can help prepare portfolios for risk transfer, and after risk transfer, liabilities will be different so portfolios will have to change.

If preparing to purchase an annuity to transfer some pension liabilities, how the plan sponsor pays for the contract will affect pricing, according to Moran. “Typically plan sponsors are paying out of plan assets, so they need to look at what securities in the portfolio are more attractive,” he says. After the transfer, since usually plan sponsors only transfer part of the plan to an annuity, plan sponsors need to change their asset allocations to match the different liability.

When offering lump sums to a group of DB plan participants, plan sponsors will be liquidating a substantial portion of their portfolios. Moran says they need to anticipate from where they will withdraw assets. “They will want to draw from the most liquid assets, so they are not paying a spread. They need to consider how this will affect the remaining portfolio after the lump-sum window.”

Moran concludes that there is always something going on in the markets, but a confluence of factors, particularly on the regulatory front, means we will see DB plan sponsors doing some different things in 2016.

Singles and Couples Face Distinct Planning Hurdles

Academics working with the Michigan Retirement Research Center have carefully developed a new retiree spending model showing singles tend to have higher medical spending in retirement vs. their married counterparts.

Findings from a new research paper, “Couples’ and Singles’ Savings After Retirement,” by Mariacristina De Nardi, Eric French and John Bailey Jones, suggest singles “live less long than people who are part of a couple, but are more likely to end up in a nursing home in any given year.”

For that reason, the researchers suggest, a single should expect to have higher medical spending than a member of a couple.

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As stated in the paper and an accompanying explanatory brief, the researchers worked to “model the saving problem of retired couples and singles facing uncertain longevity and medical expenses in [the] presence of means-tested social insurance.” The team’s goal was to identify a data-based methodology for evaluating the complex interplay of the various saving motivations and investment opportunities for couples and singles in this situation.

Explaining the key features of their model, the researchers note that a couple’s assets tend to drop sharply with the death of a spouse. “By the time the second spouse dies, a large fraction of the wealth of the original couple has vanished, with the wealth drops at the time of death of each spouse explaining most of the decline,” the paper says.

The researchers therefore observe that a large share of the decline in assets of a given retired couple over time is due to the high medical expenses most people face preceding death. “This suggests that a large fraction of all assets held in retirement are used to insure oneself against the risk of high medical and death expenses,” the paper says.

This does not exactly line up with the conventional wisdom that singles and couples slowly spend down assets in a smooth fashion over time, for example to cover basic living expenses. 

Still, many retired U.S. households, especially those who are couples and have high income, do in fact spend their assets very slowly, “and many people die with large amounts of wealth,” the paper continues. “Basic life cycle models, with no uncertainty, cannot match these patterns. This raises the question of what drives retirees’ saving behaviors. An important complementary question is how the behavior of couples compares with that of single people.”

NEXT: Spending patterns are noisy 

The researchers find being in a couple during retirement “allows its members to pool their longevity and medical expense risks, but also exposes each member to their spouse’s risks, including the income loss that often accompanies a spouse’s death. Because about 50% of Americans age 70 or older are in a couple and about 50% are single, the answers to this question are key in understanding how the elderly’s savings and welfare would respond to potential policy reforms.”

The trio of researchers go on to show that medical expenses and government-provided insurance are important for revealing the saving patterns of single U.S. retirees at all income levels, including high-permanent-income individuals who keep large amounts of assets until very late in life.

“Another important benefit of our methodology is that our model can be used to infer the effects of changing age or family structure on annuitized income for the same household,” the researchers conclude. “For example, our estimates imply that couples in which the male spouse dies at age 80 suffer a 40% decline in income, while couples in which the female spouse dies at age 80 suffer a 30% decline.”

Some of the other implications of the model are downright astounding and show just how variable the retirement planning outlook can be from individual to individual. “For example, a 70-year-old single man at the 10th permanent income percentile in a nursing home expects to live only 2.9 more years, while a 70-year-old married female at the 90th percentile in good health, married to a 73-year-old man in the same health state, expects to live 18.6 more years.”

De Nardi is a professor at University College London, a faculty research fellow at the National Bureau of Economic Research, and a research fellow at the Institute for Fiscal Studies. Eric French is a professor at University College London and a senior economist and research adviser at the Federal Reserve Bank of Chicago. John Bailey Jones is an associate professor in the Department of Economics at the State University of New York (SUNY) at Albany. 

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