In the epic poem, The Rime of the Ancient Mariner, the Mariner is blown off course by a storm and spends the rest of the poem battling to return to the safety of port.
Many sponsors of underfunded defined benefit (DB) plans can probably relate to his plight. Burdened by an albatross of unfunded liability about their necks, and mired in the doldrums of low corporate bond rates, funding ratios are often “as idle as a painted ship upon a painted ocean.”
There are only three ways that a sponsor can attempt to return to full funding. Most benefit advisers should be well versed in all three: Investing in high-return seeking assets, investing in a mix short and long duration bonds, and infusing the plan with cash.
Investing in high-return seeking assets like equities can quickly improve funding ratios. This comes with significant risk, however, as equity winds have been known to suddenly change direction.
Investing in a mix short and long duration bonds can help stabilize the plan. When interest rates rise, short duration bonds outperform liabilities and the funding ratio improves. Conversely, longer durations that match liabilities reduces funding ratio drift. In this case, the funding ratio doesn’t benefit as much from rising rates, but it is protected should the tide go out again and rates drop.
Adding cash to the plan, which is expensive, but the only sure way to bridge the funding gap.
The amount of cash that most organizations can afford to invest in their plan will be limited, so some combination of all three elements will be required. The problem is that the first two also introduce risk that the funding ratio could decline further.
The greater the gap, the more likely it is that the sponsor will bet heavily on option number one, figuring that the potential upside outweighs downside. Likewise, the fixed income mix will be heavily tilted towards shorter durations, hoping to take full advantage of rising rates. This tends to look like a more “traditional” investment allocation with 60 percent in equities and 40 percent in short duration bonds. A sustainable funding policy may also be employed to help sail towards full funding.
Assuming a year of fair market conditions, equities would generate positive returns and interest rates might rise about 1 percent. This would push the liabilities of a typical DB plan down 10 to 15 percent, while core bonds would only lose about 4 percent, for a net return of 6 to 11 percent vs. liabilities. In short, the funding gap would narrow.
Seek a safe harbor
All too often, however, the sponsor “doubles down,” hoping for another positive year. Portfolio risk is not reduced, and the plan becomes acutely vulnerable to any shift in market direction.
Advisers should help their clients understand that what’s missing from this sort of thinking is the wisdom of calibrating the portfolio’s degree of risk with the need to take it. Since the funding ratio is already closer to full, the pressure to maintain such a high exposure to equities is reduced. And with higher interest rates in place, extending the duration of fixed income holdings to match that of liabilities enables the plan to better withstand a subsequent interest rate reversal. Cutting equity exposure to 30 percent and extending fixed income duration would decrease funding ratio volatility significantly, while still maintaining some upside potential.
The closer the plan gets to full funding, the more it will benefit from this type of duration-matched bond strategy. As the funding goal nears, the sponsor has the opportunity to set the plan’s allocation to 100 percent fixed income with durations matching that of the liabilities. This would provide a safe harbor for the portfolio, which is now protected from the vicissitudes of the equity markets and corporate bond rates.
Such a strategy has a formal designation. Many advisers may already know that It is known as a “2-Dimensional Dynamic Asset Allocation”– the two dimensions being fixed income weighting and duration.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
No investment strategy, such as diversification or asset allocation, can guarantee a profit or protect against loss in periods of declining value. Use of Dynamic Asset Allocation does not guarantee improvement in plan funding status nor the timing of any improvement.
Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise.
Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group® (Principal®), Des Moines, IA 50392.
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