Majority of DB plans should question the traditional derisking glidepath

Conventional wisdom would suggest that most U.S. defined benefit pension plans are “hard frozen” — closed to new participants and not accruing liabilities. This common perception is informed in part by regular media coverage of high-profile plan freezes and buyouts. As a result, the pension community tends to focus on risk management strategies that are tailored to the needs of these plans. Pension conferences abound with discussions of the one-size-fits-all “glidepath” approach, which promises to manage portfolio risk responsibly — but perhaps overly simplistically for most pension plans.

Yet in reality, frozen plans account for a minority of U.S. defined benefit plans — and the glidepath approach that's best suited for them is often suboptimal and even painful for plans that are still accepting new participants and/or accruing obligations to existing ones.

Those still-accruing — either open plans, or those closed to new participants — account for approximately 70% of U.S. defined benefit plans, according to data from the Pension Benefit Guaranty Corp. We call them the “Forgotten 70%” because of the pension community's tendency to overlook their needs. Instead of the mechanistic glidepath, these plans might be better off considering a more flexible and holistic approach to risk that maximizes returns based on the plan's unique circumstances and tolerance for risk.

The typical glidepath is a mechanistic approach that formulaically moves a plan's assets away from growth-oriented assets and toward liability-hedging fixed-income allocations as the plan's funded status increases. For frozen plans, which will not experience future increases in the obligations they must pay out to participants, the glidepath can be an effective way to reduce surplus risk although, even in this case, a more flexible approach might result in superior outcomes.

But the Forgotten 70% have different characteristics, different risk profiles and different investment needs. For them, implementing the wrong glidepath might actually lead to lower returns at a higher level of risk, locking in higher required contributions down the road.

For plans to meet their obligations, they must eventually pay out to participants in two ways: asset returns or sponsor contributions. Unlike frozen plans, the liabilities of an open or closed plan continue to grow over time as employees earn additional benefits. Consequently, these plans have clear incentives to achieve excess returns, however, they might need to think more creatively about their risk budgets beyond simply taking on more surplus risk.

The Forgotten 70% might be better served by building efficient portfolios that reflect their individual risk profiles, and which they can alter as circumstances and risk tolerance change.

Plans can start by defining their unique tolerance for funded status risk. This is informed by several variables: current funded status, the size of the plan relative to the sponsor's balance sheet, the size of potential contributions relative to the sponsor's expected free cash flow, and the correlation of the sponsor's operating risks with the pension plan's assets.

Portfolio construction can then begin. It should focus on controlling risk both within and between the growth and liability-hedging portfolios. Many successful plans work to diversify growth assets among non-traditional sources of beta and high-alpha-potential investments, an approach that can help them achieve a higher expected return than the typical glidepath approach — with a comparable (or in some cases, lower) level of risk.

More specifically, hedge funds and active long-only strategies can play a powerful role in the Forgotten 70%'s portfolios. Alpha-focused hedge funds that are less directly correlated with equity market returns can be especially useful for some pension plans. (Of course, stringent due diligence and manager selection are key when evaluating and allocating to hedge funds.)

In addition, plans with longer time horizons and lower current liquidity needs might benefit from growth-oriented strategies such as private equity, venture capital and opportunistic credit, which can generate returns well in excess of public equities.

For instance, a defined benefit plan that implements a passive equity and liability hedge approach — as often used by mechanistic glidepaths — might need to have a 50% allocation to low-returning liability hedging assets to balance a 50% allocation to passive equities to stay within its risk tolerance.

Unfortunately, this strategy might result in returns below a plan sponsor's performance goals, and the return gap could become larger as the sponsor adheres to the typical glidepath over time. For example, for a hypothetical $1 billion plan, the return gap of 150 basis points between a 6% and 7.5% expected return translates into $270 million shortfall over 10 years. This is the pain of the mechanistic glidepath approach, and this gap would have to be covered by increased contributions.

Using a holistic risk management approach, plans integrate high value-add managers and strategies into their growth portfolio, diversifying directional equity beta exposure and therefore allowing a higher overall allocation to growth assets. Critically, despite higher allocations to growth assets relative to the mechanistic approach, it is possible for resulting allocations to produce higher expected returns with lower expected risk.

In short, holistic risk management strategies provide additional levers to control surplus risk and generate excess returns. For the 70% of U.S. defined benefit pension plans that are accruing benefits or accepting new participants, it's worth keeping this in mind — and remembering that the one-size-fits-all glidepath approach could be a dangerous cop-out.

David Druley is the global head of pension practice at Cambridge Associates, based in the Boston office.