In the years since the 2008 financial crisis, corporate defined benefit plan sponsors have been hit with one headwind after another.
First, lending dried up, then business conditions deteriorated dramatically. New mark-to-market pension valuation rules established before the crisis both pushed up the value of pension plan liabilities and made them more volatile.
The result? Once-fully-funded plans turned into underfunded ones, and already-underfunded plans slipped deeper into a hole. Eventually, some plans recovered but not back to fully funded levels. So not only did executives across industries have to figure out how to stabilize their businesses, they often had to also write big checks to the pension plan.
“The concept of supporting a corporate defined benefit plan has come up much higher on the C-suite agenda,” said Owais Rana, a managing director and head of investment solutions at Conning. “Rather than corporates focusing on sales and growth, they have been distracted by plan funding concerns.”
Today, while an extended bull market in stocks has improved the asset side of pension plans’ balance sheets, low long-dated bond interest rates have kept upward pressure on the liability side.
Rana noted that while the funded status of most corporate defined benefit plans has improved just slightly, only about $500 billion of the roughly $3 trillion in corporate DB assets has moved into some form of liability-driven investment (LDI) strategy.
The three main options for pension plan sponsors to alleviate pension funding pain are to offer lump sums to their qualifying members, implement an LDI program or a pension risk transfer transaction.
“If you want to effectively deal with the pension-funding problem, and you want to keep the plan on your balance sheet,” Rana said, “you need to have a good LDI strategy such that if there are capital market fluctuations, particularly interest rates, you’re not being called upon to make significant and unexpected contributions.”
Understanding risk is the key to how Conning structures and manages LDI strategies and it frames the firm’s approach to building solutions specific to each plan sponsor.
“Every plan’s liability obligation is different and every plan sponsor’s risk appetite is different, and every plan balance sheet is different,” Rana explained. “Hence an LDI framework needs to be customized.”
He added that for many plan sponsors, particularly those with plans that are closed or frozen, there is more downside risk than upside potential once the plan has become fully funded, and that’s one reason why a focus on risk is important. Setting up an investment strategy based on a downside-risk-management framework allows a plan sponsor to see how low its funding level could go in a worst-case scenario. From there, Conning can establish a risk budget.
“Once I know what that risk is, I can ask myself: ‘Can I live with it?’” Rana said. “We translate the answer into an LDI strategy. And we can make changes to the LDI strategy to try and reduce that tail risk without giving up too much, if any, upside potential.”
One lever the firm uses is the mix between growth assets and LDI (or fixed income) assets. The other, where Conning has built its reputation, is the construction of the LDI strategy to augment returns while remaining within a client’s downside-risk budget.
“The downside risk budget needs to be considered in conjunction with each company’s balance sheet,” Rana concluded. “How strong is it to withstand that potential downside loss in funding level, which will translate into shareholder money being poured into the pension plan or used directly for the benefit of shareholders?”