Look for a renewed risk-management focus to prompt more pension plan sponsors to make investment-strategy changes that lessen their worries about interest rate risk and equity market volatility.
Eighty-five percent of sponsors characterize pension risk as “very” or “extremely” important, ranking higher than concerns about investment returns, according to the “Survey of Defined Benefit Plan Sponsors, 2010” released in February by Vanguard. Employers most commonly worry about interest rate risk, with 85 percent citing it, followed by equity market uncertainty, which about 80 percent cited.
The interest-rate concerns stem mostly from the impact interest rates have on valuing plan liabilities, says Kim Stockton, a Vanguard investment analyst. Now, employers are looking largely to liability-driven investing (LDI) strategies to lessen the interest-rate risk, she says. Sixty-five percent of plans with $1 billion or more in assets are increasing their fixed-income corporate allocation, as are 52 percent of mid-sized plans with $100 million up to $1 billion in assets. Seventy-four percent of large plans and 47 percent of mid-sized plans are lengthening portfolio duration.
And in this environment, interest-rate hedging appeals to a lot of plans. “You can hedge interest rate risk if you look at the liability as a projected bundle of cash flows to be paid in the future,” says Susan Mangiero, founder of Fiduciary Leadership, LLC, a consulting firm that works with plan sponsors on risk management. “But even if you enter into an interest-rate hedge, it may not be 100 percent protective. There may be a structural issue that needs to be fixed. It is not a cure-all.”
So some employers make plan-design changes, says Vanguard Chief Actuary Evan Inglis. “Plan sponsors can move to a cash balance plan, because it does not have nearly the interest-rate sensitivity that a traditional pension plan does,” he says. But that strategy has a catch, he adds: “It is not well-recognized in the industry that a cash balance plan does not set up as well for matching liabilities with the assets.”
The second most common concern, stock market uncertainty, predictably has led 47 percent of mid-sized sponsors surveyed to decrease their domestic equity allocation. “I see more defined benefit plans taking money away from long-only equity and putting it into something else” such as alternative investments, Mangiero agrees. Or if plans want to keep their asset-allocation mix the same, she says, they can do an equity hedge using derivatives.
Some employers remain wary of de-emphasizing equity, Mangiero says. “I have had people say to me, ‘If we invest more in equity, we lose the equity risk premium and our funding problems will be made worse,’” she says. How to move toward an LDI strategy without a lot more funding needed “is the $64,000 question for pension funds now,” she says.
For many plans, Mangiero says, it makes sense to walk before running by implementing LDI gradually. Vanguard often talks to employers about phasing in a higher bond allocation over a five-year timeframe, Stockton says.
The LDI approach requires a mindset change for many pension sponsors. “This idea that a lower-risk portfolio is based on the funded status is different from the mindset that a lot of plan sponsors have had, which is about managing the volatility of the assets,” Inglis says. “We always recommend making changes to the asset allocation gradually, in a dollar-cost-averaging kind of approach. This is largely to control the risk of regret” if an investment committee makes a big shift and subsequently realizes that it did not time it ideally.
