When to De-risk a DB plan?

Several members of the KCS consulting team returned from the Opal Public Funds conference in Newport, RI, encouraged that DB plan sponsors were starting to understand that measuring and monitoring a plan’s liabilities is as important as following the assets on a regular basis, if not more important!  The word liabilities, often absent during previous conferences, was mentioned quite often, and not just by us or Ron Ryan.

However, as encouraged as we were, we still are concerned that plan sponsors remain skeptical of what this greater transparency and awareness of the plan’s liabilities will do for them, especially for DB plans that are underfunded.  Well, how many aren’t, especially among public and multi-employer plans?

I guess that we shouldn’t be surprised given that most sponsors (and their consultants) still feel that achieving the return on assets assumption (ROA) is the primary objective, instead of funding the benefits at the lowest cost.   With a return focus, any mention of de-risking the plan immediately raises concerns about the plan’s ability to achieve that ROA target.  While in Newport, it became apparent that most plan sponsors only feel that it is appropriate to consider a de-risking strategy when a plan is 85%-90% funded.  Why?

One of the plan sponsor panelists during the conference shared that their plan had been 104% funded at one point, but was now 68% funded (on an economic basis?).  As we’ve highlighted, most plans were fully funded at the end of the ’90s, so this story is not unique, but it is disconcerting.  Especially when one considers that after 8+ years of an equity bull market and 35 years of a bond market that has been virtually in a falling rate environment, does it make sense to believe that DB plans can generate outsized returns over the next decade?

Wouldn’t it make more sense to reduce some of the risks in the portfolio, while securing the near-term retired lives, than to subject the entire corpus to the ups and downs of the capital markets?  A de-risking strategy will be unique to each plan, as each plan’s liabilities are like snowflakes. The funded status of the plan and the plan’s ability to contribute will determine how much of the plan will be shifted to defense from offense.

We encourage plan sponsors that currently have an allocation to active fixed income to use those assets to begin the process of de-risking.  The current interest rates sensitive portfolio will be converted into a cash matching strategy that will ensure that benefits are covered for the foreseeable future while extending the investing horizon for the balance of the growth assets, whose objective is to beat liability growth.

Furthermore, liabilities are highly interest rate sensitive (like bonds), and if the U.S. economy can ever begin to produce economic growth, generate some inflation and see rates rise, the present value of the liabilities may actually decline.  Importantly, in an environment of negative liability growth, assets do not need to achieve the ROA to begin to whittle away at the funding deficit.

We encourage you to begin to de-risk your DB plans before the markets take it upon themselves to significantly impact your current funded status.  One should begin this process with a goal to fully fund the plan within 10-15 years.  A 60% funded status plan will not be fixed overnight, but a 60% funded plan that gets hit with a 25% equity market decline could be out of business before the next bull market resumes!

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