4 keys for fully funded defined benefit plans to manage risk

In a recent interview, Michael Jarasitis, institutional portfolio manager and pension strategist at Fidelity Investments, spoke about the challenges and solutions for defined benefit plans as they near or achieve 100% funding. Here is a summary of four important areas of focus he identified.

The little details matter

When you achieve full funding, considerable change occurs, and a lot of the risk is removed from the plan. If all or most of the equity risk is gone, the remaining risk is in the hedging portfolio. That’s when it’s time to sweat the small stuff. Much of that sweating should be done by the investment manager to ensure that the yield curve is aligned precisely to liability and the credit hedge is appropriately aligned, too.

What the plan sponsor should focus on is collaborating with the investment manager to ensure the mandate is on point. That includes nuances such as whether you want to hedge the percent funding or the dollar funding—the dollar surplus, let’s say. When you have 20% in equity, that’s creating enough volatility that it really doesn’t matter. But if you’re not at a stage where you’re trying to tightly lock down risk, there’s a slightly different hedging approach depending on whether you’re hedging the percent funding or the dollar funding.

Those little details matter, along with defining your target—do you want to hedge the projected benefit obligation (PBO) liability? Or do you want to hedge present value of future pension plan benefit (PVFB) liability? If you choose PFVB, it takes into account future service costs for plans that are still accruing on some level of services but entails more actuarial variations. There are trade-offs to consider, and plan sponsors should work with their investment managers to set the right target.

Understand the real world of managing credit risk

With lower or even no equity risk, credit risk is the primary concern related to funding level and potential drawdowns. For a liability, the rule is to use AA or higher corporate bonds. Of course, the discount rate doesn’t have to go out and buy bonds to populate that discount curve—it’s all very theoretical.

In the real world, the universe of AA or higher is narrow. We don’t believe you can operate solely in that universe and have a portfolio that we deem prudent in terms of diversification and liquidity—and liquidity can be more challenging at the long end of the curve. That means you should consider expanding beyond the AAs and go outside of the liability.

Our approach to achieve the diversification and liquidity we deem appropriate is to move out to investment-grade bonds at the A and BBB level. The BBBs have greatly increased in terms of percentage of the overall investment-grade market over the last 10 years, which to some extent forces your hand to expand out there to get that liquidity and diversification. Even if you’re not going into high yield or private credit, you are taking on some credit risk just by extending AA to BBB. You can balance that by adding Treasuries, which have the duration sensitivity that you want, but theoretically avoid credit risk.

If you think about a risk-off environment where spreads are widening, typically BBs will be trailing the liability that’s AA, but the Treasuries will be beating the AA liability. If you correctly calibrate them, they’ll all move in tandem—which is the key and is something the investment manager needs to worry about. We have done significant research and analysis and concluded that, generally speaking, BBBs move about 1.7 times relative to AAs. So, if you want to think in terms of beta to the liability, it’s about 1.7.

There have been extreme environments where that BBB beta may sell off at three times as much as AAs. Those are the environments where you’ll be hurt the most—but they have been rare and very short-lived over the past 30 years. COVID's onset was one of the most extreme instances, and that lasted just a few weeks. Even if you had a drawdown of 5%–10% of your funded status, it came back very quickly.

Account for fees that could decay your funded status

When your portfolio is focused on return seeking, it’s easy to cover fees. Once your portfolio’s only job is keeping pace with the liability, there’s nothing outpacing the liability. If you’re right around 100% funded, as time passes you can see PBGC fees, for example, increase year over year. If you have a high headcount, those fees can decay your funded status. So even within a bond portfolio, you want to make sure you have some excess yield to cover those fees over time. If you’re 105%–110% funded, it’s less of an issue because you have more dollars working on your behalf—it’s easier to add a little gravy on top of the liability to cover fees.

Know what success looks like

The ultimate definition of success when you’re fully funded is never having to contribute to the plan again. At that point, it’s about measuring that your mandate is effective in hedging all the risks that are out there—predominantly interest rate risk and credit spread risk. In these later stages, we advocate for having the liability itself act as the direct benchmark and measurement. Since, as mentioned earlier, the liability is not a real investible object it’s a good idea to have an investible index proxy next to that so you can determine whether your manager is picking the right bonds relative to what’s available. But the primary focus is keeping pace with the liability and making sure funding is not decaying over time.

A second sign of success is making sure that you do have some ways to cover fees if they are degrading the plan over time, even by a small amount. Just a little excess yield in the portfolio can typically cover that over time. Of course, you want to balance that excess yield with the potential drawdown that could also require contributions.

A final measure of success is tied to the company’s ultimate goals. Do they want the plan to remain on the balance sheet with stable funding and no impact to the financial statements or to earnings. Just set it, forget it, and sunset it over time—what’s often referred to as hibernation. Or do you want to do a risk transfer and annuitize it to an insurer? Those are slightly different goals. In the hibernation phase, success is marked by stable funding and no contributions. In plan termination, success is ultimately offloading it to the insurer at a reasonable cost and executing from an operational perspective.