Defined benefit (DB) sponsors prefer stability. Small changes in interest rates and stock values make it easy to manage the funded status of a plan. In contrast, rapid changes in interest rates and volatile stock returns, particularly a shift to lower interest rates and lower stock values, can reduce funding status and cause several problems.
A recent blog post by Kevin Turner and Justin Owens of Russell Investment, Funded Status Volatility: Why It Matters to Retirement Plans, summarizes the potential impact of funded status volatility: “A significant decline in funded status can lead to larger, unexpected contribution requirements for plan sponsors lead when the funding of a plan falls below a certain level. Funded status volatility can also affect Pension Benefit Guarantee Corporation (PBGC) premiums. If a plan’s funded status drops at the wrong time, PBGC rewards can rise significantly due to the decrease in funded status. “
Funded fluctuations in status aren’t just a problem for the biggest plans, however. Royce Kosoff, General Manager of Willis Towers Watson, notes that all DB plans are subject to external market forces and can benefit from a range of volatility management techniques. “Whether you’re a small plan sponsor, a medium plan sponsor, or a large plan sponsor, managing the financial volatility of retirement programs is critical,” he says. “All sponsors need to understand the risks on both the investment side and the liabilities side. The numbers can have an additional digit or two, but the concepts are still similar. “
Effects on the market
Owens, director of Investment Strategy and Solutions at Russell Investments, says market moves over the past few years have challenged DB’s plans. Lower discount rates, which can be traced back to the global financial crisis, have increased the plan liabilities. On the other hand, strong returns on stocks have raised funding status, but are generally not enough to offset lower interest rates. However, during the same period, downward volatility in equity markets was a problem.
“The last time stocks were down significantly in the first quarter of 2020, some defined benefit sponsors saw their funding status decline by more than 10%,” Owens said. “A few years ago, up to the fourth quarter of 2018, there was also a significant decline in the stock markets, which led to a decline in the financing status. Overall, however, it has been a challenge for defined benefit sponsors during this period to maintain a stable funding position unless they have taken steps to reduce the volatility of their funding status. “
It is tempting to dismiss funding status as an annual issue only, because so often are sponsors having to review their funding status for accounting disclosure requirements and calculate dues and PBGC rewards. However, over the past decade it has become common for plan sponsors to measure funding status more frequently, in some cases even daily, Owens says, because they have changed their investment strategy to plan based on the company’s funding position.
Owens cites the example of a frozen defined benefit plan that has a goal and glide path for transitioning from a traditional 60/40 stock / annuity portfolio in its currently funded position to a 20/80 portfolio once the plan is 105% is funded. “To make this transition step by step, rather than all at once, you need to track your funding status more often,” he explains. “The vast majority of defined benefit sponsors, at least medium-sized and wholesale, track their funding status at least monthly and more often daily so they can make progress on their glide paths.” Tracking the plan more often and making adjustments based on its status can help maintain a more stable funding status, he adds.
Tame the swings
Russell Investments developed what is known as the three-legged chair approach to reduce the volatility of funded status. The first step is to develop an additional diversification of the plan’s stock allocation to stabilize returns over time. The second part is to address interest rate risk due to its impact on the valuation of plan liabilities.
“We want to take steps to manage the sensitivities of the liabilities by investing in assets that move in the same way as the liabilities,” says Owens. “For example, a long-term fixed-income mandate is very common in defined benefit plans, because with falling interest rates and rising liabilities, part of the assets also increases in order to hedge the interest rate risk and stabilize the financing status time.”
The third leg is often overlooked in the industry, claims Owens. Instead of looking at assets and liabilities in isolation, it makes more sense to look at the plan more holistically. This includes studying the interaction between the income-oriented assets and liabilities.
“The fixed income assets help hedge interest rate risk, but they may also provide protection against high risk to the stocks,” says Owens. “[We also] Take a look at the equity portfolio and see how this correlates with liabilities since liabilities have a spread component in them. “The aim is to understand“ what gives the best stability in the funded status and reduces the volatility of the funded status, rather than looking at each piece of wealth in isolation, ”he explains.
According to research by Russell Investments, this approach works. Citing the results of the plans from 2020, the paper reports: “When it comes to financed status changes, the data shows that the monthly path for our DB customers was much smoother than is usual in the industry. This more predictable experience was particularly noteworthy given the market upheaval in 2020. Because of our approach, the data shows that the volatility of funded status movements for Russell Investments clients in 2020 is only 5.3 compared to the S&P 1500 industry % was estimate of 9.7%. “
Plan sponsors differ in the degree of volatility in funded status that is acceptable to their organization, Kosoff says. Some seek a narrow range of how much this status can move, while others seek additional returns and can accept the higher level of volatility. Still, there is a need for continued asset growth and continued improvement in funding status as most plans are not fully funded at this point, he notes. “The goal is to properly balance these two factors – the need for volatility management along with the need for growth,” he says.