Pension Funds and Risk Considerations

Defined benefit plans are giving way to defined contribution plans. However, in some countries, such as Japan and the Netherlands, they are still featured prominently. This Los reviews the main factors that contribute to the risk of a DB plan.

A DB plan's risk management is influenced by the following factors:

1. Plan-funded status – A plan's funded status is determined by the difference between its assets and liabilities. An underfunded plan is at greater risk of not meeting the payouts retirees will depend upon. Ways in which portfolio managers seek to minimize this risk include:

   • Matching assets to liabilities in terms of quantity, timing, and risk using a Liability Driven Investing (LDI) approach.
   • Growing assets at a higher rate of return than the expected growth in liabilities – which typically involves taking on more investment risk.
   • Investing in more defensive assets is expected to deliver less volatile returns. A willingness for the plan sponsor (employer) to increase plan contributions over time will help alleviate the increased volatility of plan assets.

2. Sponsor financial strength – the financial wherewithal of the company is an important consideration. This can often be quantified with fundamental analysis (earnings, debt ratios, revenues, etc.). Also, the relative size of the plan and the firm's balance sheet and earnings is another important factor. Large firms with smaller plans are at less risk.

3. Interactions between the sponsor's business and the fund's investments – recently, regulations have attenuated the amount of the sponsoring firm's equity allowable as an investment in the DB plan assets. This is basic diversification at work. If the sponsoring firm does poorly, and its own equity shares represent a large number of plan assets, the firm could find itself with shrinking plan assets at exactly the same time it loses plan contribution potential.

4. Plan design – refers to the setup of the plan, including formulas for benefit payments, suitable investments, etc. Both the adequacy and sustainability of the plan need to be balanced. As an employee retention tool, firms would prefer to promise ever-increasing benefits to employees in the future. However, this must be tempered with realistic expectations about what contribution rates may be sustainable in the future and what a realistic return on plan assets should be. The risk, in this case, would be overly optimistic expectations on behalf of the plan sponsor.

5. Workforce characteristics – younger workforces have a longer time-to-retirement (investment horizon) and therefore may take on more risk. In addition, since benefit payments are further in the future, more liquidity risk may be taken on. An older workforce lowers plan risk-taking ability and raises liquidity needs. It also means more vested employees, which reduces plan-funded status.

Already retired employees also affect plan risk. As retirees live longer, the fund comes under increasing levels of longevity risk.

Question

In mitigating the risk to plan funded status, all but which of the following are common methods:

1. Using a Liability-Driven Investment approach,
2. Growing assets at a higher rate of return than the expected growth in liabilities,
3. Investing in more cyclical assets, willingness for sponsor to increase contributions.

Solution

The correct answer is C.

While willingness to increase contribution rates is correct, a focus on investing in defensive assets is preferable as compared to cyclical assets. While cyclical assets may have a higher total expected return, they will have higher volatility and may begin to perform poorly as the plan sponsor is also beginning a downward trend economically. This represents a double whammy which can be alleviated with a higher concentration of defensive assets in the plan's portfolio of investments.

A and B are incorrect. An LDI approach focuses on the liabilities side of a balance sheet by seeking to ensure all expected future payouts can be met. Rather than seeking an absolute return target (focusing on the asset side of the balance sheet), the target return can be set just high enough to realistically satisfy the expected future liabilities, these decreases taking any unnecessary risk with plan assets. This approach also opens the door for surplus optimization. Increasing plan assets as compared to plan liabilities will increase funded status, a marker of a less risky plan.

Portfolio Construction: Learning Module 5: Portfolio Management for Institutional Investors; Los 5(e) Evaluate risk considerations of private defined benefit (DB) pension plans in relation to 1) plan funded status, 2) sponsor financial strength, 3) interactions between the sponsor's business and the fund's investments, 4) plan design, and 5) workforce characteristics