Prepare DB Clients for Lower Equity Returns

According to Mercer’s list of top ten priority areas of focus for defined benefit (DB) plan sponsors as they manage their plans and seek to enable participant success, Equity and bond returns have been negatively correlated, providing a powerful diversification effect. However, moving forward, investors need to be prepared for lower equity returns due to declining optimism, the end of the economic cycle or economic/political shocks.

 

Mercer says pension plans may want to consider explicit hedges, implicit hedges, accelerated glide paths, defensive tilts and the additional flexibility provided by high-quality cash.

• Other points on Mercer’s list include:
  Understand tax reform as a game changer: Tax reform has important and time-sensitive implications for pension funding strategies. Approximately 75% of plan sponsors were already accelerating pension funding or considered doing so in 2017 with the prospect of lower taxes. Other key funding drivers include reducing PBGC variable rate premiums and funding over a shorter period to meet specific funding thresholds. Tax reform includes a reduction in the headline corporate tax rate from 35% to 21%. This makes pension pre-funding for many tax-paying plan sponsors more compelling than ever before. It is estimated that many will take the opportunity to realize a higher deduction sooner, rather than later, and also realize the potential benefits of improved earnings, reduced PBGC premiums, neutralized impact on any deferred tax asset and acceleration of movement along an existing glide path.
• Prepare for transition from quantitative easing to quantitative tightening: The levers of monetary and fiscal policy are now working against each other, as the Fed tightens monetary policy while the administration seeks to expand fiscal stimulus. DB plan sponsors face a perplexing conundrum: funded status is likely to fall or move sideways despite very strong markets and pension liabilities will be highly sensitive to movements in discount rates. As tax reform has passed, many DB plan sponsors will likely increase contributions to take advantage of higher tax deductions. 
• Ensure bonds are fit for purpose:  Ensure fixed income bonds are poised for growth. The late stage of the credit cycle tends to be a more challenging period for investment returns. It is increasingly important to construct bond portfolios carefully and tailor them to a DB plan’s specific liabilities and investment strategy.
• Drive performance of investment returns: Plan sponsors are increasingly applying performance attribution analysis to determine whether a portfolio’s returns are due to manager skill, luck or to persistent biases in a portfolio. Factor-based strategies can be deployed and replicated at relatively low cost; however, excessive reliance on continued outperformance of a factor can lead to significant style bias and potential for divergent performance from the broader market.
• Manage private asset classes: Plan managers may be willing to accept the illiquidity of private assets for an expected long-term premium. But illiquidity can create challenges as plans de-risk or make substantial distributions. Investors should incorporate liquidity considerations into their plans for executing glide paths.
• Develop an investment governance model: One approach that has grown rapidly is the outsourced chief investment officer (OCIO), or delegated, investment management model. Plan sponsors should review their governance model and determine any potential benefits to moving to a new one.
• Identify the right risk transfer strategy: The business case for risk transfer has become increasingly compelling considering the dramatic increases in PBGC fees, existing financial risks and operational complexities. Market and plan dynamics will have an impact on pricing, and engaging the insurer marketplace early in the process will help bring clarity to the potential financial outcomes and sensitivities.
• Check hibernation portfolio: A confluence of factors is driving plan sponsors to accelerate risk transfer actions. As more marketable obligations are transferred to insurers, residual DB plans will have unusual and idiosyncratic features that make them more difficult to manage. Plan sponsors need to understand which parts of the liability are difficult to market to insurers and develop a plan for the remainder of the liability that needs to be placed in hibernation.
• Address data reliability and gaps: Data presents a much more significant risk to a transaction than may be appreciated. Before de-risking, plan sponsors should address data gaps and challenges. Be in a better position to monitor the market and make quick decisions.

“DB plan sponsors face a host of challenges and powerful, priority opportunities in a rapidly changing environment of corporate tax reform, Fed tightening and emerging inflationary pressures. All of these factors could have a significant impact on pension funding and risk transfer,” says Michael Schlachter, US Defined Benefit Leader, Mercer. “As a result, plan sponsors are looking to take bigger deductions from increased contributions, address shrinking investment returns during the late stage of the credit cycle, and prepare for accelerated risk transfer.”

Mercer’s list may be downloaded from here.