Now may be the right time to derisk your defined benefit plan

In 2022, we saw one of the most unprecedented movements in global financial markets in modern history. A combination of global geopolitical problems and supply-demand imbalances of goods and services due to the pandemic left the Federal Reserve (Fed) with no option but to try and slam the inflationary brake by hiking short-term interest rates to stop the economy from overheating. The capital markets across the board went downward, with the S&P 500 returning -19.6% and the 10-year U.S. Treasurys returning -16.3% over 2022.

As most investors were in despair having seen their wealth significantly depleted, there was a silver lining for at least one group of asset owners who had waited for such a scenario—the private defined benefit (DB) plan sponsor. This group of investors had been eagerly waiting for the high-quality, long- duration bonds to finally drop in value, but were still hesitant to derisk. As a result, the average funded ratio as of December 31, 2022, stood at 110%, according to the Milliman Pension Index.

It has taken almost 15 years for DB plans to finally see higher average funded ratios. This was mainly driven by a large drop in liability values that were discounted on a high-quality corporate bond yield curve. Even the explosive equity bull market era proceeding the Global Financial Crisis failed to drive the industry’s average funded status into positive territory. A commensurate rally in the long-dated Treasury (hence corporate bond) market kept increasing the plans’ liability values.

For those plans that have patiently waited for the long-dated interest rate to rise, the time may be here to de-risk by swapping out equity-like exposure in favor of fixed-income assets to lock in the funded status gains and avoid the asset-liability mismatch risk. One thing to learn from 2022 is that the long- dated interest rate is one of the main drivers of risk in liability values. In our view, this is an uncompensated risk and most of it should be hedged as part of an asset allocation strategy.

Historical funding levels, long-dated interest rate, and equity returns

As of February 29, 2024. Source: Principal Asset Management, S&P, Milliman Pension Surplus/Deficit

Is 2024 the right time to consider de-risking their investment strategy by adding to an LDI portfolio?

Based on the above assumptions, asset levels started to overtake liability levels in Q2 2023, and now, with some plans having the highest DB funding ratios in memory, employers who sponsor a DB plan might want to revisit an LDI strategy. Why?

• Objectives may already be achieved—plan sponsors working glide paths to fully fund their market value obligations may have reached their goal of termination or long-term hibernation, neither of which require large risk-seeking assets (i.e., equities). Maintaining interest rate risk exposure on unhedged liabilities is an uncompensated risk and exposes sponsors to significant downside risk.
• Bond yield volatility is now two-directional—with inflation slowing down, the Fed signaling rate cuts, and bond rates no longer pinned to the floor, real two-directional liability volatility (they can go down—and up) has returned. LDI is the usual prescription against large net losses driven by market “flights to quality” marked by simultaneous asset losses and liability increases.
• The need for gross returns is lower—higher assets relative to pension obligations mean those investments need to work less hard to keep pace with liability growth due to accruals, interest, and changes in bond rates.

New environment, new options

We recognize that not all pension plans are built the same in terms of their liability structure, sponsor’s risk appetite, their investment/risk management objectives, and their governance structure. It’s critical to understand a plan’s circumstances and develop a custom liability-driven investing strategy that is based on their specific requirements and objectives.

The first level of investments needed to develop a custom LDI strategy are typically high-quality public market credit and risk-remote assets, such as Treasury bonds, STRIPS, and interest rate derivatives. These instruments can be structured to mimic the risk exposures of the liability term structure.

The outlook for DB plan sponsors

In terms of risk reduction, many are now optimistic. More and more are predicting that the anticipated recession now may not arrive until 2025, if at all.

Short-term economic predictions aren’t always reliable. When it comes to pension risk management decisions, DB plan sponsors are well advised to temper broad market sentiment with analysis based on their circumstances and objectives.

With plan funding ratios at historic highs, plan sponsors should review their investment risk profiles. Those not needing another year of large net returns may want to consider reducing risk if not transferring risk out completely.