Rising Interest Rates and Equity Markets Create Opportunities and Risks for Defined Benefit Plans

Rising Interest Rates and Equity Markets Create Opportunities and Risks for Defined Benefit Plans

Rising Interest Rates and Equity Markets Create Opportunities and Risks for Defined Benefit Plans

The FINANCIAL -- Mercer and a wholly-owned subsidiary of Marsh & McLennan Companies on December 21 outlined key investment issues that plan sponsors with defined benefit (DB) plans should focus on in 2017 to navigate a changing political environment and uncertain financial markets.  

“Rising interest rates and equity markets have improved funding ratios, which does create opportunities for plan sponsors to take actions such as executing risk transfer actions, locking in gains and cutting risk or reducing contributions and expense,” said Richard McEvoy, Partner, Mercer. “However, the proposed policies of the US President Elect could create a meaningfully different market environment than investors have faced since the financial crisis. As such, plan sponsors should carefully evaluate next steps to optimize outcomes for their plans.” 

Mercer suggests that DB plan sponsors consider the following actions in 2017 including: 

Creating a comprehensive journey plan: Strategic journey plans should go beyond creating a de-risking glidepath. Instead, journey plans should encapsulate the full course of actions as the DB plan matures and evolves. Plans should be created in such a way that a plan sponsor is prepared to act, with a blueprint for actions and an ultimate objective clearly laid out, as opportunities for risk transfer activities arise over time.  

Growth portfolio opportunities and challenges: Ongoing changes in the financial sector provide opportunities for investors to improve their results. As one example, in the years since the financial crisis, the banking industry has edged traditional credit providers, primarily banks, out of some lending segments, creating chances for sophisticated institutional investors to provide credit at attractive rates through private debt, structured credit and similar strategies. Another industry movement - the growing potential for “reflation” - could have significant effects across many asset classes. Low yielding bonds, lower growth equity and real estate assets may also impact portfolios.  

Re-risking: Plan sponsors with DB plans may have a de-risking glidepath established, but some have not considered what to do if their funded status declines. Should they “re-risk” by moving back down the glidepath and increasing their growth allocation? The answer should be consistent with a DB plan’s long term journey plan.  

Ensure your bonds are fit for purpose: As fixed income allocations increase, tailoring the bond portfolio to each DB plan’s specific liabilities and journey plan becomes more important. Partnering with a bond manager who can help execute your journey plan and be flexible and opportunistic is also crucial.  

Funding flexibility and borrowing to fund: Funding a DB plan through borrowing has benefits such as tax deductibility of interest, stabilizing the pattern and level of payments, and decreasing PBGC variable rate premiums. The case for borrowing to fund may remain attractive despite the recent rise in rates and should be evaluated. 

Consider cashouts: The potential for a cashout at this time remains economically compelling. New lump sum mortality tables are expected in 2018, and other maintenance costs such as PBGC fees, investment and operational expenses should all be reviewed by DB plan sponsors to determine the economic trade-off of offering a cashout to terminated vested or active employees (through a spin-off). Reviewing the business case through four lenses – economic, HR & participant, portfolio & cash, and accounting implications – is important to understanding all aspects and the potential fit. 

Insurer risk transfer: A stagnant interest rate environment through 2016 did not dissuade many pension sponsors from fully terminating their DB plans or reducing risks and ‘right sizing’ their plans via purchase of a group annuity contract from an insurance company. This trend is expected to continue in 2017 and new insurers are potentially looking to enter the space and further increase the competition.  

Effective management of alts: Alternatives (alts) and private assets have the potential to add value for long term investors like pension plans, as liquidity can be traded for the expected long term return premium relative to liquid investments. Illiquidity can have its challenges though, so DB plan sponsors should approach with some considerations such as developing liquidity budgets and plan to reduce illiquid investment commitments well before settlement events are anticipated. 

Data are key: Accurate pension plan data are a critical component for any pension de-risking project. With data gaps and challenges addressed early in the process, DB plan sponsors will be able to monitor the market and make quick decisions to begin de-risking projects. 

Delegation – coordinated de-risking: Plan sponsors that delegate responsibility for directing the DB plan’s investments to an overall de-risking manager who can oversee and direct both the fixed income and growth portfolio may have greater opportunities to achieve the journey plan objectives.