The primary objective in managing a defined benefit pension is the securing of the promised benefits. Asset allocation plays a significant role in accomplishing that objective. However, there are at least two schools of thought regarding how one should manage to that objective.
According to U.S. Federal Reserve data, in 1952 the average U.S. DB pension plan had 96% of their assets in fixed income and cash equivalents. Interestingly, U.S. interest rates were not too dissimilar to where they are today. In fact, the U.S. 10-year Treasury yield was at 2.68% at the beginning of the year in 1952, which was only 3 bps different from where it started this year (2.71%). Funded status wasn’t particularly strong in those days, but minimum-funding standards hadn’t been established and wouldn’t be until the passage of ERISA in 1974.
The more conservative asset allocation created a greater dependence on contributions to fund the promised benefits, but significantly less volatility associated with the plan’s asset allocation made for greater certainty of what those contributions would look like from year-to-year!
Today, DB plans have a far greater exposure to non-fixed income through considerable investments in equities and alternatives. This significant movement was done primarily to enhance the long-term investment returns achieved by the plans making contributions a less significant part of the plan’s funding. However, the greater use of these higher risk investments has injected significant volatility into the process and has created far greater uncertainty surrounding annual contributions, especially in light of two devastating corrections in the last 18 years.
Perhaps an allocation of 96% to fixed income wasn’t the right answer in 1952, but approaching asset allocation with a gambler’s mindset of letting it ride doesn’t seem to be working either. For those of us who have been around since the late ’70s and early ’80s, you may recall the use of dedication and defeasance strategies that removed significant risk from plans by effectively matching plan liabilities and assets.
As we’ve traveled across the country discussing enhanced asset allocation strategies we’ve highlighted the need for plan sponsors to once again become more focused on their plan’s liabilities to help guide and inform investment structure and asset allocation decisions. Our approach consists of allocating a portion of plan assets to a cash flow matching bond portfolio in order to meet near-term liabilities chronologically (retired lives). The remaining assets are going to be invested with a more aggressive risk profile given that the investing horizon has been extended allowing for more time for these assets to capture their liquidity premium.
1952’s asset allocation might not be appropriate for today given constrained budgets, but living with considerable volatility of returns in a 4.5% risk premium environment doesn’t seem right either. Adopting our model will help to stabilize the funded status and contribution expense while taking every opportunity to reduce unnecessary risk in the process.