Defined benefit pension plans using a derisking glidepath should move to a more holistic approach that maximizes returns at each targeted level of risk, according to a new paper from Cambridge Associates.
Instead of simply re-allocating assets to fixed income from the growth portfolio at each funded status threshold, plans should try to maximize returns at the same level of risk by allocating to active alternative strategies such as low-beta hedge funds, distressed credit, very active long-only strategies and private investment opportunities, said David Druley, managing director and head of the global pension practice at Cambridge.
“Our problem with that is it's too mechanistic,” Mr. Druley said. “If you're trying to reduce risk … why not target explicitly the level of risk you want to take?”
Mr. Druley said Cambridge's approach works in most economic environments, but especially in the current low-interest-rate environment. Locking in low rates will result in higher contributions, he said. The average target return of pension plans is around 7%, but “you are fortunate to get 5% or 5.5% now” with the traditional glidepath, he added.
“If you are outlining the returns it will cost them, it opens up plans to considering an alternative path,” Mr. Druley said about more pension plans seeking proposals for different glidepaths that use more asset classes outside of just fixed income.
The paper said the holistic approach did a better job of protecting funded status in 2008 than the traditional glidepath. A pension plan that was 90% funded as of Sept. 30, 2007, would have been 72.8% funded as of March 31, 2009, using the holistic glidepath, compared to just 63.9% with the traditional approach. The holistic approach defines and controls risk within the growth portfolio in addition to looking at the amount allocated to growth strategies.