Pension Plan Glide Paths Need to Evolve

Art by Mark Wang

Defined benefit (DB) plan sponsors need to revisit the glide path of their pension plan at least once a year to ensure that, as its funding status improves or deteriorates, the plan’s exposure to both risk (equities) and hedges (fixed income) are commensurate to where it is on the funding status spectrum, experts say. Generally speaking, as a pension plan’s funding status improves, it will decrease its risk exposure and increase its hedging positions.

“The volatility in the marketplace has definitely pushed clients to take a closer look at the pension plans’ asset allocations, with many plans choosing to implement de-risking strategies,” says Ken Stapleton, senior institutional investment consultant at MassMutual in Enfield, Connecticut.

MassMutual focuses on middle market pension plans, those with $100 million in assets, Stapleton says. Whereas larger pension plans employ more complex investment options, MassMutual serves its middle market plans  with a “fully integrated investment and actuarial approach to guide sponsors along a de-risking path for their plan using investments and asset allocation strategies that make sense for their size and needs,” he says.

“We boil it down to a focus on funded status volatility and the three largest factors in that calculation: 1) asset allocation, 2) liability movement and 3) company contributions,” Stapleton says. This initial analysis allows MassMutual to present a number of asset allocations to achieve the investment return needs of the plan.

“We view equities as our return-seeking assets and fixed income as our liability-hedging assets, where the shift towards fixed income comes as funded status improves,” Stapleton continues. “Equities will range across asset classes and include diversifiers such as REITs [real estate investment trusts] and alternatives, while fixed income will often target the duration of the liability.”

Al Pierce, managing director at SEI Institutional in Oaks, Pennsylvania, agrees that as a pension plan’s funding status improves, its asset allocation should be de-risked. Like MassMutual, SEI approaches each client from the perspective of how much they want to contribute to the plan, how much volatility they can tolerate and the date when they would like the plan to be fully funded, he says.

For instance, if a pension plan sponsor does not want to contribute any money but has a high tolerance for volatility, they could have a glide path that does not do any de-risking until they get very close to their end target date, Pierce says. Or, if a pension plan sponsor has a $20 million deficit and is contributing $5 million a year to the plan, their plan’s glide path could very well reduce its exposure to risk, he says.

An important point to remember in all of this is, when a glide path is established, it needs to be revisited at least once a year to ensure that the goals for the pension plan are achievable, Pierce says. Those conversations could result in the pension plan sponsor increasing its contributions or changing its asset allocation.

Brett Cornwell, vice president, client portfolio manager, fixed income, at Voya Financial, agrees that as a pension plan’s funding status improves, it is important to reduce the volatility and narrow the range of outcomes so that the sponsor has better visibility into what the plan has the potential to return and what it will need to contribute.

“You are trying to make sure that as gains occur, you lock them in,” Cornwell continues. “This year has been a great indication of why it is so important to lock those gains in by moving into liability hedging assets. It is less about trying to predict the interest rate environment and more about focusing on the funding status. We definitely think managing a corporate pension plan is more than managing a long duration portfolio. You need to pivot and truly understand how the liabilities behave. Ultimately, you have to manage the portfolio in a risk-appropriate way so that the plan can meet benefit commitments.”

Cornwell says that the earliest iterations of liability-driven investing (LDI), or LDI 1.0, “was about extending the duration of the assets. As we move into LDI 2.0 and 3.0, it becomes a more complex game.”

Thomas Cassara, managing director at River and Mercantile in New York, has developed a glide path that embraces all of the concepts addressed above, but that also uses equity put and call options. “These tools can be added to a portfolio to manage equity risk in a cost effective and customized way,” he says.

Cassara explains: “For a plan sponsor holding equities, it is possible to sell off potential upside that it does not expect to need, using call options, and to buy protection against market falls using put options, forming a ‘collar’ on equity returns. Using put and call options in this way can allow a plan sponsor to hold more growth assets for longer while still reducing risk.”

Cassara says that reaction to this approach from River and Mercantile’s pension plan clients has been favorable. “They appreciate having that extra layer of risk diversification and that our approach to each pension plan is custom fit,” he says.