Pension plans have seen success in employing liability-driven investing strategies and many plans today enjoy overfunded status. They continue to pursue more refined investment derisking paths that support their funded status gains — and even grow the surplus, which they can then use for a variety of purposes, said Kevin Schuman, director of client services at NISA Investment Advisors.

“Plan sponsors should be aware that funded status volatility is a risk that can be managed internally at a low level — and in a way that funded status can continue to grow,” he said. And given today’s high funding levels, increasing funded status usually doesn’t require additional funding from sponsors.

“The tools to manage risk are significantly more developed than they were a decade ago, and typically involve a blend of a modest amount of return-seeking assets, a healthy amount of credit and a Treasury allocation,” Schuman said.

In fact, plans can successfully derisk without resorting to a pension risk transfer, which transfers the pension assets to an insurer through a group annuity contract. “Giving up that potential growth through an annuity transaction can be thought of as a wealth transfer between the plan sponsor and the insurance company. The LDI asset allocations employed in-plan aren’t that different from what the insurance companies will use in their hedges.”

Read: Bundled LDI – A Turnkey Approach for Small-to-midsize Corporate Pensions

While most corporate pension plans are close to fully funded today, or even overfunded, they are not all alike in their approach to derisking. “We see a distinction among clients’ hedging solutions based on whether they are open or closed/frozen,” Schuman said.

Closed and frozen plans are usually close to or fully hedged against interest rate risk, with their end-state portfolio allocations heavily weighted toward credit fixed income. “Their portfolios often retain an allocation to return-seeking assets barbelled with an allocation to Treasuries, which can provide stability in market downturns,” Schuman said. A modest amount of return-seeking assets within an endgame allocation can contribute to the hedge of the liability’s credit spread risk and seek upside to the total portfolio return. “This type of an allocation could potentially contribute to returns in excess of the liability.”

Open plans also have higher liability hedge ratios today compared with a few years ago, which is often the result of higher interest rates and improved funded status. But the asset allocation considerations for open plans vary widely, Schuman said. “They are all over the board with how much they have allocated to return-seeking assets.”

The glidepaths of open versus closed/frozen plans exhibit notable differences, he said. Open plans tend to maintain their return-seeking allocations to achieve higher potential returns and avoid the need for future contributions. “For open plans, the slope of the glidepath is typically gentler, because they seek to reduce the cost of ongoing service accruals with market returns from the return-seeking allocation,” he said.

For any plan, the use of a completion portfolio lets them maintain their desired allocation to return-seeking assets while simultaneously increasing their liability hedge. “The great thing about completion portfolios is that hedge increases can be accomplished within a short amount of time by adding more Treasury-based derivatives and without necessarily selling any return-seeking assets or adjusting actively managed fixed-income benchmarks,” Schuman said. More than 50 NISA clients have changed their hedge ratio targets since the end of 2021 by using completion programs.

Plan sponsors should be aware that funded status volatility is a risk
that can be managed internally at a low level — and in a way
that funded status can continue to grow.

Kevin Schuman

NISA Investment Advisors

Closed or frozen plans can use LDI tools to seek and support the surplus, Schuman said. “A hibernated plan can be designed to have only a modest amount of tracking error against its liabilities but also seek annual excess return between 50 and 100 basis points.”

A modest amount of return-seeking assets and active fixed income are tools that can be used to improve funded status. Additionally, in a high-rate environment, funded status surpluses have the potential to accumulate, he said.

Targeting modest surplus improvements doesn’t require a 60% equity allocation or abandoning LDI. “Rather, it’s something that can be done around the edges using the significant liability-hedging knowledge that we have accumulated over the last 20 years.”

Read: Liability Driven Investing – Primer

IBM’s recent decision to reopen its defined benefit plan, giving current employees new benefits funded by its large pension fund surplus, is a potential game changer for the industry, according to Schuman. “IBM has always been an early adopter, and our hope is they are going to be seen as an early mover in a DB resurgence.”

It’s important to remember that IBM had been an underfunded plan as recently as 2012, he noted. “If they had done a large annuity transaction or plan termination, they would have lost the opportunity to achieve the surplus and the ability to reopen their DB plan. Essentially, the surplus growth would very likely have ended up with the insurance company that they would have transacted with,” he said. “We think this is a key consideration for any plan thinking about an annuity transaction today.”

In the past, sponsors may not have seen an upside to holding on to an overfunded plan, but no longer. “Now, IBM has shown a clear benefit to a risk-controlled approach to increasing the surplus, and we hope plan sponsors everywhere will re-examine the benefits of keeping their DB plans on the books.”

Since IBM’s announcement, Schuman said he’s had many related conversations with clients — not always about reopening DB plans, but rather about other ways to potentially use their surplus. “Historically, a surplus has been viewed as trapped, difficult to access and of very little value. We couldn’t disagree with that more.”

Besides reopening a plan, there are several potential uses for a surplus. For instance, a surplus can be transferred to fund retiree medical benefits, and though such a transfer involves complexities, SECURE 2.0 has lowered the funding threshold to 110%. “Mergers and acquisitions are another potential use for a surplus. A sponsor with an overfunded plan can merge with an underfunded plan,” he said. In addition, plan sponsors can also use the surplus to support workforce management by providing additional benefits that can help retain employees or be used in severance packages.

The improved funded status of defined benefit plans has increased their ability to derisk. Many plan sponsors are exploring pension risk transfers, which are annuity transactions that offload pension liabilities to an insurer. In that process, they are exploring several approaches on their PRT journey — particularly with annuity buy-ins — to meet their different needs.

“Plan sponsors are thinking about how they can use surplus assets to lock in funded status gains and derisk their plans,” said Kerri Dantos, vice president and actuary of pension risk transfer at Prudential Financial. “Many frozen plans have finally gotten to a place where they can afford to terminate, and we’re seeing increased pension risk transfer activity as a result.”

Read: Pension Buy-Ins: The Nimble Strategy Taking Pension Risk Transfer to the Next Level

The PRT market is seeing an uptick in group annuity buy-ins, which are an important derisking tool for plan sponsors. “Buy-ins have many use cases that aren’t always well known,” Dantos said. For instance, in addition to helping plans prepare for a buyout or full termination, a buy-in can function as an asset allocation tool.

“In a buy-in, the financial risk of some or all of the covered participants is transferred to the insurer, but the assets (which now include the buy-in contract) and liabilities stay within the plan,” she said. “In recent years, buy-ins have gained popularity as a tool to derisk during plan termination.” Sponsors can use the buy-in contract to lock in their annuity purchase costs upfront. “It’s a great way to derisk during the termination process because there’s so much uncertainty,” given the typical time period involved.

Terminations can take from 12 to 18 months, leaving plans vulnerable to fluctuations in markets and interest rates, Dantos said. “By the time you get to the point where you’re finally settling benefit obligations, market conditions can be very different from when you started the process. A lot of sponsors want to eliminate that volatility to avoid a surprise cash contribution at the end.”

“With a buy-in, you’re immunizing against all of the market risks that you could potentially face leading up to the termination,” she said.

Buy-ins are an attractive “set it and forget it” strategy that can be useful for many different situations, Dantos said. “During a plan termination, a buy-in serves as a short-term strategy that can mitigate investment risk, credit risk, and funded-status volatility. Prior to termination, a buy-in can be used as part of a long-term asset strategy to reduce funded-status volatility and immunize the covered population.”

While we see many buy-ins for plans that are terminating, it can also be
a good strategy for open or ongoing plans to use a partial buy-in 
as part of their asset-liability management strategy.

Kerri Dantos

Prudential Financial

Buy-ins can also be attractive for pension plans beyond providing the ability to negate changing market conditions and lock in costs prior to a planned termination. “While we see many buy-ins for plans that are terminating, it can also be a good strategy for open or ongoing plans to use a partial buy-in as part of their asset-liability management strategy,” Dantos said.

Consider a partial buy-in as an equivalent to a fixed-income investment that precisely matches the liability, which is not the case with traditional liability-driven investing strategies. “LDI strategies have become more sophisticated, but even the most sophisticated strategy still has some gaps,” she said. For instance, assets may have credit risks, which don’t move in tandem with liabilities, and on the liability side, there are demographic risks like longevity that can’t be hedged through assets.

In contrast, “a buy-in, as a guarantee to reimburse all future benefits, is a perfect hedge for the plan’s liability cash flows,” Dantos said.

The transaction can allow a plan to change its overall asset allocation mix, and consider increasing risk, by derisking the portion of the portfolio that the buy-in covers. “When rebalancing the remaining plan assets, you can now reinvest a higher allocation of those remaining assets in growth-seeking securities without increasing the overall risk of the portfolio,” Dantos said.

For example, a buy-in could cover 25% of a plan that is allocated 60% to fixed income and 40% to equity. “That 25% buy-in contract replaces part of the fixed-income allocation, and the remaining 75% doesn’t need to keep that same 60/40 mix,” she said. Instead, the allocation mix can be adjusted: Fixed income reduced because it is already covered by the buy-in, and equity increased. “If you’re trying to maintain a similar overall risk profile, that means the remaining assets can potentially be invested more aggressively.”

Read: An innovative partnership to zero-out pension risk

When it comes to PRT, pension plans can take several approaches to prepare their investment portfolios ahead of a transaction. Underlying all of them is the need to establish a transparent and trusted partnership with an insurer.

One PRT approach that Dantos highlighted is an asset-in-kind transfer, where the plan transfers its assets to the insurer versus converting them to cash. “Plan sponsors that engage in large risk transfer transactions often see a benefit from transferring assets directly from their pension trust to the insurer as part of the premium,” Dantos said. Asset-in-kind transfers can reduce transaction costs and can also lead to lower premiums from insurers because they avoid the expense of rebuilding a portfolio.

Dantos indicated three main factors that insurers consider when evaluating plan portfolios for a potential transaction: portfolio size, credit quality and maturity profile. “Typically, plans benefit when they have a large portfolio weighted towards single-A bonds with remaining maturities between 10 and 30 years.”

When it comes to the transfer of illiquid assets and any customized features that are part of the transaction, Prudential Financial “works closely with the plan sponsor to monitor how market changes will impact the premium,” she said.

Not all insurers are alike however, and each insurer’s appetite for different asset classes changes frequently. Dantos suggested that plan sponsors reach out to insurers to form a constructive partnership, long before the PRT actually takes place. “Work in partnership with your insurer to develop the optimal strategy, learn which assets they prefer, determine what changes can be made within your own portfolio to align with those goals — and start those conversations as early as possible,” she said.

P&I’s Pension Derisking Conference, to be held Oct. 8 and 9 in Atlanta, takes a deep dive into derisking approaches, including hibernation and termination, across a day and a half of sessions with panels, presentations, interactive discussions and keynotes. Attendees will also access the latest thinking on the market environment, comparative trends and broader issues in pension derisking.