Investment strategies for frozen DB plans
April 1, 2019
Over the course of the last 15 years we have seen an increase in the number of frozen corporate defined benefit plans in Canada.
Frozen plans have limited the future benefit accruals in the plan, either through closing membership to new employees or, in some cases, freezing future service accruals to existing members. This fundamental plan change reduces the size and importance of the pension over time. At the same time, the time horizon of these plans are also reduced. As a result, the company objectives often change, since frequently the primary focus of the company becomes the replacement DC plan. As well, since future accruals are restricted, the DB plan may not require the same investment growth. These factors may create a desire to reduce risk of unexpected funding volatility. As a result, frozen plans may consider the following strategies:
Reducing equity weighting – Equity strategies are inherently more volatile than fixed income strategies. As mentioned above, there may be less need to generate asset growth in a frozen plan, where accruals are restricted. Where the plan is in a deficit position, maintaining a higher equity weighting may remain desirable, to reduce the long-term funding costs. However, many frozen plans will adhere to a de-risking plan that will systematically reduce equity weightings as the funding position improves.
Higher allocations to fixed income – The pension obligations owed by a pension plan can be viewed conceptually as shorting a bond – the pension payments mirror the regular bond coupon payments paid out by the bond issuer. Accordingly, a higher allocation to fixed income represents a reduction in interest rate mismatch risk, since falling interest rates that increase the cost of pension liabilities will simultaneously result in capital gains in the bond portfolio.
Lengthening fixed income duration – The duration of the liabilities of a pension plan may range from 12-20 years, depending on the plan formula and demographics. This creates an interest rate mismatch for most universe bond funds, which will have a shorter duration (typically six to nine years).
For an active plan this mismatch could be desirable in the current low interest rate environment. When interest rates ultimately rise, the shorter duration universe bond fund will fall by less than the longer duration liabilities, improving the plan funding position. However, for frozen plans this represents mismatch risk. A drop in interest rates, as experienced in 2018, would result in an undesired erosion in the plan funded position. Of course, for a plan in a deficit position, a small interest rate mismatch may be a preferred method of reducing the funding deficit to a higher equity weighting.
Yield enhancement strategies – For plans still employing a duration mismatch, the yield enhancement in a shorter bond allocation could be achieved through an allocation to mortgages, investment grade or high yield credit. Yield enhancement with a longer duration could be achieved through an allocation to real estate or infrastructure assets. These yield enhancement strategies do carry some degree of risk, as the yield spreads could widen relative to safer government bonds in times of economic upheaval. However, they may offer a more controlled way to improve funding than increasing the equity allocation.
Immunization – Immunization strategies are designed to build a fixed income portfolio that matches the bond inflows to the pension obligations. For plans that are underfunded, immunization will sustain any deficit, which must be made up with continued funding contributions. However, for plans that are fully funded, immunization is a way of taking the investment risk off the table. Of course, this will not protect the plan from longevity risk.
Annuitization – Annuitization involves using the pension fund assets to buy annuities from an insurance company for all or a portion of the plan’s liabilities. With buyout annuities particularly, when members retire, their pensions are payed by the insurance company. Annuitization eliminates all investment and longevity risk. However, buyout annuities may not be an effective alternative for underfunded plans or those with continued service accruals.
As frozen DB plans continue to mature and funding levels improve over time, the goal for many will be to minimize the business risks assumed through the DB programs. To achieve this outcome, we would expect the investment policies of these plans to continue to migrate to strategies designed to increase the predictability of the programs and reduce the chances of unexpected funding erosion.