Current Thinking

Navigating the New Defined Benefit Pension Plan Landscape

Whether you are looking to restructure benefits, improve investment performance or reduce costs, the landscape for defined benefit pension plans is changing. Banks not only need a pension solution for today, but a roadmap for the next 5 to 10 years and beyond. There are several approaches that can be designed to align plan assets and investment strategies with future benefit liabilities.

Today, pension costs are on the rise due to minimum required contribution funding anomalies; assumption changes due to increasing lifespans; and rising Pension Benefit Guaranty Corporation (PBGC) premiums.

Further, plan funding volatility is exacerbated by changing interest rates. The Fed appears to be on the path of increasing interest rates, which in turn typically reduces plan liabilities and closes the gap on pension funding shortfalls. The assumption that as interest rates go up, plan liabilities go down further leads to the assumption that required contributions will then also go down. But in reality, minimum required contributions will most likely go up, at least over the short term.

As an example: Currently, minimum required contributions use an interest rate slightly lower than 6 percent. Real market interest rates are slightly below 4.25 percent. When rates increase on a real market basis, the plan’s funding shortfall is reduced as liabilities decrease (assuming non-bond-related investments remain unchanged).

However, on a funding basis, liabilities and normal costs remain the same because they are being valued at approximately 6 percent to begin with. But assets invested in bonds will lose value and thus create more unfunded liabilities – which increases the minimum required contribution. Over time, however, as funding rates converge to real market rates, the real funding shortfall will decrease as interest rates rise further.

So what is the best strategy for investing your defined benefit plan assets? There are two approaches: the total return investment strategy, and the liability-driven investment strategy. The first, more typically seen in the marketplace, is more heavily weighted towards equities than fixed-income; over the long run, it will generally give you a higher rate of return. Of course, it also tends to give you more volatility on a year-by-year basis.

The second strategy’s premise is that your investment returns should dovetail with, or match, the liabilities that are going to come due in the pension plan. The duration of a typical pension plan is 12 to 15 years. At least in theory, you could hedge your liability risk by investing solely in long bonds. But for a number of reasons, I do not believe that anyone employs a purely liability-driven investment strategy.

Part of asset management within a defined benefit plan is to diversify the portfolio, which includes determining your strategy: Are you looking to simply mitigate risk (particularly interest rate risk), or are you looking to offset future additional costs?

We typically see five types of portfolios:

Long-term growth equity strategy, in which you invest in both actively and passively managed equity vehicles, and hold a broadly diversified mix of equity for exposure to the U.S. and non-U.S. equity markets. This approach is designed to help offset the impact of salary-based benefit accruals of active employees on future liabilities. It often uses a “core and satellite” structure, where the core investments can include index funds representing major markets, like the S&P 500, while the satellite investments include several actively managed portfolios that serve to provide further diversification, including growth and value styles.

Long-term growth fixed-income strategy, which can lead to a more balanced portfolio in the long run. Here you invest in actively managed fixed-income vehicles, primarily intermediate-term bonds with a focus on “core plus” fixed-income, which includes the U.S. investment grade fixed-income market, opportunistic commitments to high-yield and non-U.S. debt, and possibly other types of bond-oriented funds. This approach is designed to contribute to asset growth over the long term. Also note that there is a limited correlation to the plan’s liabilities given the portfolio’s intermediate-term duration.

Alternative investment asset portfolio strategy, consisting of a diversified portfolio that may include hedge funds, private equity, commodities, real estate and professionally-managed private funds. This approach is also designed to contribute to asset growth over the long term.

Liability-focused investment strategy, which is designed to hedge interest rate risk. This involves a high-quality fixed-income portfolio that is structured via investment in bond funds; it may also include a portfolio of individual bonds. It can serve as your primary liability-driven investment tool. Its typical duration is longer than 10 years.

Interest rate overlay strategy, wherein the portfolio is used opportunistically in conjunction with a long-term fixed-income strategy as a liability-driven investment tool. This strategy typically holds a pool of derivatives, primarily interest rate swaps and futures, and is used to opportunistically increase the duration of plan assets and to hedge plan liabilities that are greater than 30 years.

There are of course a variety of other factors to consider when navigating the defined benefit pension plan landscape, but I hope that this article gives you food for thought. Just keep in mind: There are a lot of options available depending on your goals; discussing them with a professional will pay benefits in a number of ways.

NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities or adopt any particular investing strategy. Past performance is not a guarantee of future results.