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The Case Against Boring Pension Portfolios

Researchers contradict the idea that liability-driven investing is best for corporate plans.

There is such a thing as too much fixed income for corporate pension fund portfolios, new research shows.

As companies have closed and frozen their defined benefit plans en masse, the vast majority have implemented a bond-heavy strategy for liability-drive investing. But shunning riskier asset classes comes at a cost for beneficiaries, according to the recent paper “Should Corporate Pensions Invest in Risky Assets?” by University of Iowa professors Wei Li and Tong Yao, and Southern Illinois University at Edwardsville’s Jie Ying. If plan sponsors can’t handle the volatility of stocks, hedge funds, private equity, and real estate, they should move to a defined contribution plan structure. 

The research contradicts the view held by some defined benefit plan sponsors that given their fixed-income-like payouts, they should engage in liability-driven investment strategies, which rely on fixed-income assets to secure returns. 

According to the research, this isn’t exactly beneficial for employees. Here’s why: many employees rely on their pension funds completely for retirement savings, according to the research. Regardless of how their plan sponsors invest, these employees are taking on some risk because their pensions could be wiped out if their employers file for bankruptcy. And while the Pension Benefit Guaranty Corp. (PBGC) provides insurance for pension funds, retirees are only insured up to a ceiling, the paper noted. For higher-paid employees expecting to retire with large pensions, a bankruptcy could spell trouble.

“Employees have some desire to have a fair risk-return tradeoff,” Li said by phone Thursday. “They would prefer to have some risk exposure.” 

Because they already must take on some risk, it makes more sense for employees to seek out higher yields on investments, the research argued. Indeed, plan sponsors are incentivized to share their pension surpluses with employees via tax benefits, according to the paper.   

So why are some defined benefit plans still investing using liability-driven investment strategies? They have strong incentives, like corporate tax advantages, to invest in less risky assets, the research shows.  

What’s more is that these plan sponsors don’t gain anything from taking on riskier investments beyond full funding: the value added to their portfolios from these risky investments is passed onto employees, the research shows. When those more volatile investments fall, they can reduce the plan sponsor’s value as a company, according to the paper.  

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There is, perhaps, a better way to distribute the risk fairly according to the paper: defined contribution plans. These plans make up 48.6 percent of pension assets in the seven major pension fund markets, according to Willis Towers Watson, and are steadily increasing their market share. Assets under management at these defined contribution plans increased by 5.6 percent over the past 10 years, while they grew by 3.1 percent at defined benefit plans during the same time frame, the report shows. 

“A more efficient contract would let employees to shoulder all the pension investment risk while keeping them insulated from firm-specific risks,” according to the paper. “Interestingly, this arrangement resembles what a defined contribution plan offers. Our analysis shows that such an arrangement may substantially reduce firms’ pension funding costs.”

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