Defined benefit (DB) plan sponsors prefer stability. Modest changes in interest rates and equity values make it easier to manage a plan’s funded status. In contrast, rapid changes in interest rates and volatile equity returns, particularly a shift to lower rates and lower equity values, can reduce funded status and cause multiple problems.
A recent blog post by Russell Investment’s Kevin Turner and Justin Owens, “Funded Status Volatility: Why It Matters for Pension Plans,” summarizes the potential impacts of funded status volatility: “Significant drops in funded status can lead to larger, unexpected contribution requirements for plan sponsors if a plan’s funding drops below a certain level. And funded status volatility can also impact Pension Benefit Guaranty Corporation (PBGC) premiums. If a plan’s funded status drops at the wrong time, PBGC premiums can increase significantly due to that funded status decline.”
Funded status swings aren’t just a problem for the largest plans, though. Royce Kosoff, managing director with Willis Towers Watson notes that all DB plans are subject to external market forces and can benefit from a range of volatility-management techniques. “Regardless of whether you're a small-plan sponsor, medium-plan sponsor or a large-plan sponsor, managing the financial volatility of retirement programs is crucial,” he says. “All sponsors need to understand the risks on both the investment side and on the liability side. The numbers may have an additional digit or two, but the concepts are still similar.”
Owens, director of investment strategy and solutions with Russell Investments, says that market movements in recent years have challenged DB plans. Lower discount rates, dating back to the global financial crisis, have increased plan liabilities. On the other hand, strong returns from equities have increased funded status, but generally not enough to offset lower rates. During the same period, though, equity market volatility to the downside has been a problem.
“Most recently, in the first quarter of 2020, we did see a significant downturn in equities in which some defined benefit plan sponsors saw a drop in their funded status of more than 10%,” Owens explains. “Going back a couple of years to the fourth quarter of 2018, we also saw a significant drop in equity markets that led to funded status decreasing. But overall, during this time period, it's been challenging for defined benefit plan sponsors to maintain a stable funded position, unless they've taken steps to reduce their funded status volatility.”
It’s tempting to dismiss funded status as just an annual concern because that’s how frequently sponsors must review their funding status for accounting disclosure requirements and to calculate contributions and PBGC premiums. But over the last decade or so it's become common for plan sponsors to measure funded status on a more frequent basis, as frequently as daily in some cases, Owens says, because they have changed their investment strategy to be based on the funded position of the plan.
Owens cites the example of a frozen defined benefit plan that has a goal and glide path to transition from a traditional 60/40 equities/fixed income portfolio at their current funded position to a 20/80 portfolio once the plan is 105% funded. “In order to make this transition step-by-step, instead of all at once, they need to be tracking their funded status on a more frequent basis,” he explains. “So, the vast majority of defined benefit plan sponsors, at least in the mid-market and large-market, are tracking their funded status at least monthly and more commonly daily so that they can make progress on their glide paths.” Tracking the plan more frequently and making adjustments based on its status can help maintain a more stable funding status, he adds.
Taming the Swings
Russell Investments has developed what it calls the three-legged stool approach for reducing funded status volatility. The first leg is to develop added diversification in the plan’s equity allocation to help stabilize returns over time. The second leg is to address interest-rate risk because of its impact on plan liabilities’ valuation.
“We want to take steps to manage the sensitivities in the liabilities by investing in assets that move the same way as the liabilities,” says Owens. “For example, a long-duration fixed income mandate is very common within defined benefit plans because when rates go down and liabilities go up, a portion of the assets also goes up to hedge the interest rate risk and stabilize the funded status time.”
The third leg is frequently overlooked in the industry, Owens maintains. Instead of looking at assets and liabilities in isolation, it makes more sense to approach the plan more holistically. This involves examining the interaction between the return-seeking assets and the liabilities.
“The fixed income assets help to hedge away interest rate risk, but also at the same time they may be able to provide tail risk protection for the equities,” Owens says. “[We also] look within the equity portfolio and see how that might be correlated to the liabilities because there is a spread component in liabilities.” The goal is to understand “what is going to provide the best funded status stability and reduce the funded status volatility rather than looking at each portion of the assets in isolation,” he explains.
According to Russell Investments research, this approach works. Citing plans’ results from 2020, the paper reports: “When it comes to funded status movements, the data shows that the monthly path for our DB clients has been significantly smoother than what was typical in the industry. This more predictable experience was especially noteworthy amid the market upheaval of 2020. As a result of our approach, the data shows that the volatility of funded status movements for Russell Investments’ clients was only 5.3% in 2020, in contrast to the S&P 1500 industry estimate of 9.7%.”
Plan sponsors differ in the degree of funded status volatility that is acceptable for their organization, says Kosoff. Some seek a narrow band around how much that status can move, while others pursue additional asset returns and can accept the higher volatility level. Still, there is a need for continued asset growth and continued funded status improvement because most plans are not fully funded at this point, he observes. “The goal is to appropriately balance those two factors—the need for volatility management along with the need for growth,” he says.