In Benefits and Pensions Monitor, RiskFirst’s Michael Carse, DB Pensions Product Manager, examines the US de-risking landscape, and how pension plans can leverage market changes and technology capabilities to implement a de-risking strategy that is right for them.

Recent US market developments are presenting increasingly attractive conditions for de-risking, causing many pension plans to revisit and evaluate their existing risk-transfer strategies. But what should pension plans consider when selecting the path that is best for them? And how can plans that decide to act implement de-risking strategies effectively? Michael Carse, DB Pensions Product Manager, RiskFirst, examines the de-risking landscape, best practice for implementation and discusses how technology can play a fundamental role in supporting plans throughout their de-risking journey.

Many US defined benefit (DB) pension plans would state their “end game” as being either one of hibernation – creating and maintaining a low-risk portfolio – or of termination – with the aim being to remove risk from the table as early as possible. But is it truly as clear cut as “hibernation versus termination”, and do plans really need to make a choice to commit to one or the other?

The short answer is “no”. The vast majority of plans will, in fact, ultimately arrive at the same place: termination. While hibernation may be an effective strategy for much of the journey, pension plans cannot remain in hibernation indefinitely; there comes a point when every plan, regardless of size, will need to shift gear and opt for termination. It is deciding when the optimal time is to act and transfer the residual that is key.

With this in mind, it is crucial that pension plans revisit their strategy on a regular basis, have the flexibility to change course as and when needed according to changing circumstances and requirements, and have a clear understanding of market conditions, movements and corresponding impacts to their plans in order to ensure they make the optimized decision for them – at the right time.

Shifting markets

Any decision, of course, needs to factor in the specific situation of that individual pension plan. However, a number of market factors are presenting favorable conditions to de-risk, resulting in many plans re-evaluating their strategies.

The first of these market developments is the recent legislative accounting reforms implemented by The Financial Accounting Standards Board (FASB). These changes to US accounting standards stipulate the movement of pensions assets and liabilities (with the exception of service cost) away from operations reporting, altering where different components of pension income and costs, including expected return on assets (EROA) income, appear in accounting disclosures. This could affect how sponsors view their investment strategy and could also potentially help to reduce obstacles to de-risking.

Secondly, tax reforms. The 2018 plan year is the last opportunity to maximize a pension plan’s tax deduction prior to the lower corporate tax rate (decreasing from 35% to 21%[1]) coming into effect. Many sponsors may therefore look to take advantage of higher deductions at current rates by accelerating contributions – further reducing the funding gap in the short-term and increasing the incentive to transfer risk.

Thirdly, equity market performance. Despite some recent volatility, equity markets continue to perform strongly – particularly relative to liabilities (which have benefitted from some increases in bond yields). General improvements in funded status create opportunities for asset allocation changes, increasing a plan’s interest rate and credit hedge ratios. Indeed, with US plan deficits decreasing (falling to US$375 billion in 2017 from US$408 billion in 2016) and material improvements in funded ratios (the estimated aggregate funded ratio of pension plans sponsored by S&P 1500 companies increased from 82% to 84% year-on-year as of December 31st2017[2]), the likelihood is that more plans are crossing the threshold of being fully funded – and thereby more plans are potentially in a position to de-risk.

Lastly, PBGC (Pension Benefit Guaranty Corporation) premiums. Variable-rate premiums in particular have seen substantial increases introduced under the Bipartisan Budget Act, with figures showing that PBGC variable-rate premium income grew by 81% year-on-year in 2016. Such figures have been rising sharply over the last decade in fact – seeing a twenty-fold increase since 2008 – and they are predicted to increase further. Increased income for PBGC translates to increased costs for pension plans. With costs escalating, there is growing incentive for plans to transfer the risk.

Optimizing risk transfer: timing

In the face of these converging factors, de-risking is becoming an increasingly attractive option for US pension plans. But to de-risk at the optimal time, plans need be able to readily assess the impact of market changes on their own position. Making decisions based upon the most recent year-end figures, or undertaking the task of bringing those figures up-to-date in response to a market development, is impractical and time consuming. Indeed, being able to react and adapt quickly to change is key, increasing the potential number of opportunities to take action to help ensure plan performance can be optimized. This is all the more important in today’s pension landscape, in which assets and liabilities are changing in more complex ways and being impacted by more factors. Trigger-based strategies – which rely on accurate daily tracking of funded status for different liability measures, liability discount rates and bond yields – can play an important role in this respect.

What’s more, plans need to have a holistic understanding of their position – in terms of assets, liabilities and risk. With up-to-date, granular information across both sides of the balance sheet, plans can create optimal duration hedged or cashflow-matched investment portfolios that are effectively matched to its liabilities; test portfolio solutions from multiple perspectives; and optimize performance targeting within an agreed risk framework.

As well as understanding their existing position, plans need to be able to evaluate the potential impacts of decisions on future positions. Undertaking detailed analysis and scenario testing on assets and liabilities enables insights into the plan trajectory –enhancing understanding of short and long term risk, and allowing plans to make more informed decisions regarding the right choices for them.

Optimization algorithms can also be used to determine the optimal hedging portfolio from an interest rate and credit perspective, while achieving a desired portfolio return through a diversified growth portfolio. Longer-term projections can then also be undertaken to help convey a plan’s ultimate net cost to the sponsor.

Optimizing risk transfer: implementation

For many, termination may not currently be the optimal path. But for those looking to de-risk, there are a number of ways in which risk transfer can be implemented, and a number of things to consider.

The steps a plan will need to take will depend on the specific de-risking decision made and the reasoning. As a general rule, in the immediate term, a selection of assets that are being used to back the risk transfer will need to be held in short-term liquid assets. Following the finalization of the risk transfer, it may be the case that the remaining liabilities have altered significantly; in this instance, it will be necessary to carry out a detailed review of the plan’s asset allocation – particularly its hedge portfolio.

If a plan seeks to reduce risk over a period of time, harnessing new opportunities as they arise, it can be useful to implement a glidepath strategy, with targeted liability-driven investment (LDI) portfolios at given points in time. Technology can add substantial value to glide path management, allowing for more effective implementation of customized asset allocation glide path strategies. Trigger-based strategies can be employed alongside glide path strategies, alerting when triggers have been breached and positioning plans with the information they need to make timely, effective decisions, and transfer risk when markets are favorable.

Whether or not a plan decides to de-risk, having accurate and up-to-date information is vital – and is all the more important the closer a plan gets to its intended destination. Equipped with a holistic understanding of its position and effective scenario analysis capabilities, plans can be confident they have the tools they need to make the decisions that are right for them and at the right time.

This article was first published by Benefits and Pensions Monitor