Many U.S. corporate pension plans have seen funding levels materially improve in recent years. Strong equity markets and higher rates have put many plans near or above 100% funded. This is a critical inflection point after many years of plan sponsors seeking to achieve this level. The goal now shifts to preserving this funded status. To achieve this, the approach to managing the plan and potential risks must also change.
The little details matter
When you achieve full funding and materially de-risk the plan, the focus must shift. If most or all the equity risk is gone, funding volatility will be lower, which is good. The remaining risk, while smaller, lies in the hedging portfolio. That is when it is time to sweat the small stuff. Much of this should be done by the investment manager to ensure that the fixed income portfolio is aligned precisely with the liability cash flows.
What the plan sponsor should focus on is collaborating with the investment manager to ensure the hedging mandate is aligned with their goals. This includes nuances such as whether you want to hedge the percent funding (funded status) or the dollar funding. When you have, say, over 20% in equity, that exposure is creating enough volatility that it does not matter. But if you are now at a stage where you are trying to tightly lock down risk, the funding target can meaningfully impact the result. There is a slightly different hedging approach depending on whether you are hedging the funded status or the dollar funding.
Those little details matter, along with defining what your target is—this includes factors such as discount rate and liability type. Which discount rate do you want to use for the hedging liability? An above-median curve may be used by the plan sponsor for GAAP1 reporting. But this may increase risk when attempting to hedge in the real world. Do you want to hedge the projected benefit obligation (PBO) liability, or do you want to hedge the present value of future pension plan benefit (PVFB) liability, which includes future service costs? There are trade-offs to consider, and plan sponsors should work with their investment managers to set the right target.
Understand the real world of managing credit risk
With lower or even no equity risk, credit risk is a central concern related to funding level and potential drawdowns. For a liability, the accounting rule is to use AA or higher corporate bonds to discount the liability. Of course, the discount rate does not have to go out and buy bonds to populate that discount curve—it simply applies the yields in a theoretical approach.
In the real world, the universe of bonds rated AA or higher is narrow. We do not believe you can operate solely in that universe and have a prudent portfolio in terms of diversification and liquidity—and liquidity can be more challenging at the long end of the curve. That means you should consider expanding beyond the AAs and go outside of the liability.
Our approach to achieve the diversification and liquidity we deem appropriate is to move out to investment-grade bonds at the A and BBB level. BBB-rated corporate bonds have increased in terms of percentage of the overall investment-grade market over the last 10 years. This forces your hand to expand to this part of the market to get sufficient liquidity and diversification. Even if you are not going into high yield or private credit, you are taking on some credit risk just by extending from AA or higher to BBB or higher. You can balance that by adding Treasuries, which have the duration sensitivity that you want but avoid credit risk.
If you think about a risk-off environment where spreads are widening, typically BBBs will be trailing the liability comprised of AA or higher bonds, but U.S. Treasuries will be outpacing the AA liability. If you correctly calibrate them, portfolio and liability should move in tandem and provide a reliable hedge. We have back tested across many scenarios and, in general, BBBs move about 1.7 times relative to AAs. So, if you want to think in terms of beta to the liability, it is about 1.7.
There have been extreme environments where that BBB beta may sell off more than 1.7 times as much as AAs. Those are the environments where you will be hurt the most—but they have been rare, short-lived, and tended to quickly reverse.
Account for fees that could decay your funded status
When your portfolio is focused on return seeking, it is “easy” to cover fees. That is, while the potential for funding loss in any given period is higher, over the long-term, equities have proven to outpace liabilities, including fees. Once your portfolio’s only job is keeping pace with the liability, there is less risk premium to potentially outpace the liability. If you are right around 100% funded, as time passes, fees such as the insurance premiums paid to the Pension Benefit Guaranty Corporation (PBGC)2, can decay your funded status. So even within a bond portfolio, you want to make sure you have some excess yield to cover those fees over time. If you are 105-110% funded, it is less of an issue because you have more dollars working on your behalf—it is easier to add a little gravy on top of the liability to cover fees.
Know what success looks like
For most plan sponsors, the definition of success when you are fully funded is stable funded status and minimal, if any, contributions to the plan. At that point, it is about measuring that your mandate is effective in hedging all the risks that are out there—predominantly interest rate risk and credit spread risk. In these later stages, we advocate for having the liability itself function as the direct benchmark. Since, as mentioned earlier, the liability is not a real investible object, it is a good idea to have an investible index proxy next to that so you can determine whether your manager is picking the right bonds relative to what is available. But the primary focus is keeping pace with the liability and making sure funding is stable in the near-term and not decaying over the longer term.
Another measure of success is tied to the company’s ultimate goals. Do you want the plan to remain on the balance sheet with stable funding and minimal or slightly positive impact to the financial statements? Just set it, forget it, and sunset it over time—what is often referred to as hibernation. Or do you want to do a risk transfer, annuitize it to an insurer, and remove it from the balance sheet entirely? Those are different goals, but both require a tight hedging portfolio to be achieved. In the hibernation phase, success is marked by stable funding and little to no contributions. In plan termination, success is offloading it to the insurer at a reasonable cost and executing from an operational perspective. The key to success in either case is identifying the risks the plan faces at this stage and implementing the appropriate investment strategy.
Learn more about Fidelity Institutional Pension Investment Solutions
Michael Jarasitis is a pension strategist in the Fidelity Institutional group at Fidelity Investments. Fidelity Investments is a leading provider of investment management, retirement planning, portfolio guidance, brokerage, benefits outsourcing, and other financial products and services to institutions, financial intermediaries, and individuals. In this role, Mr. Jarasitis works closely with corporate defined benefit plans to develop and execute custom de-risking solutions. He also provides capital market perspectives and represents the investment process in the marketplace.
1Generally Accepted Accounting Principles (GAAP) is a set of accounting rules and procedures used to prepare financial institutions.
2PBGC premiums are annual insurance payments made by sponsors of defined benefit pension plans to the Pension Benefit Guaranty Corporation (PBGC), a federal agency that insures these plans. PBGC pension insurance premiums are set by Congress.
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