Are Low Interest Rates An Impediment to Derisking a DB Plan?

We had a very interesting conversation with a plan sponsor prospect recently who was intrigued with the idea of beginning to derisk their DB plan but had been cautioned by their asset consultant that the strategy made no sense in this low interest rate environment.  We strongly disagree with the consultant’s conclusion.

First, and without question, every DB pension plan should have a glide path in place to derisk their plan as the funded ratio and funded status improves.  This does not mean you only do it as your plan’s funded ratio exceeds 90%.  It certainly means that a plan with a 90% funded ratio should have a very different asset allocation than one with a 50% funded ratio.  Unfortunately, because most plans are focused on the ROA, most plans striving for the same ROA will have very similar asset allocations.

Second, when the topic of de-risking is raised, most consultants immediately think of LDI strategies, that most often try to match durations at an average duration of the liability stream (usually 12-15 years). We would agree that sticking a bunch of fixed income assets out on the curve in order to try to match a segment of the liability stream doesn’t make much sense.  There is a lot of interest rate risk in this strategy, especially when one considers that there will likely still be a big mismatch between assets and liabilities given the average funded status of plans in this country.

What KCS and Ryan ALM espouse is a cash-matching strategy that immunizes the nearest retired lives, and extends out this strategy as the funded status improves. A cash matching immunization is a much more precise implementation than one that tries to match durations.  Currently, most DB plans have a decent exposure to domestic fixed income despite the low rates. With our strategy, one migrates that current fixed income into the immunization portfolio.  With this move, the plan sponsor reduces the interest rate risk, improves liquidity to meet future net cash flows, and extends the investing horizon for the remaining assets.

These residual assets are the growth assets whose job it is to beat liability growth and not the ROA.  As the growth portfolio meets with success, siphon the excess assets and port them to the immunized portfolio.  This migration of assets will be used to extend the glide path toward full funding.

Regrettably, most plans did not consider a de-risking strategy in the late 1990s when most public and private plans were well-funded.  This oversight has cost DB plans billions, if not trillions, in additional contributions and lost opportunity cost.

Lastly, plan sponsors who fear that this strategy will compromise their ability to earn a rate of return in excess of the ROA should know that the average yield on a cash-flow matched portfolio will likely be greater than the average yield on a Barclays Aggregate-type portfolio. Why? The immunized portfolio will have a yield advantage because most of the bonds will be BBB and A (still investment grade) thus enhancing a plan’s ability to meet the asset objective.

Many DB plans have been helped by returns during the last 8+ years of equity market returns, but despite these outsized gains, few plans are fully-funded.  Equity returns will likely be muted during the next decade.  Furthermore, another market decline similar in magnitude to the 2000-2002 and 2007-2009 corrections would likely drive many public plans to seek relief through defined contribution offerings, which would only exacerbate the retirement crisis unfolding in our country.

 

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