Editor’s Note: This is the second in a three-part series on pension plan funding. It features discussions with Brad Smith, Partner at consultant and investment firm NEPC and member of its Corporate Defined Benefit Team. The first installment is here; this one looks at some aspects of how plan funds are invested.
How plan funds are invested has a direct effect on pension plan funding. NEPC’s Brad Smith offers some ideas on some aspects of investing those funds and considerations.
One way that plan assets can be allocated is to liability-driven investments. Why does this matter? Says Smith, “Plan liabilities are valued by measuring the present value of future expected benefits.” He explains that “the actual value of pension liabilities is very sensitive to changes in interest rates. A typical plan’s liabilities can increase or decrease by 10%-14% in a single year for every 1% change in rates.
“It is also worth noting that long bond pricing (i.e., LDI investments) is also very sensitive to changes in interest rates,” Smith continues. “Allocating pension assets to LDI investments allows a portion of plan assets to move in tandem with the value of liabilities as interest rates fluctuate. Increasing the correlation between the value of assets and value of liabilities helps reduce unexpected changes in the value of assets and liabilities (funded status volatility). LDI helps plan sponsors better manage interest rate risk and reduces funded status volatility in a changing interest rate environment.”
Shifting asset allocations can have various effects; for instance, shifting asset allocations when there is a strong market environment, could materially reduce expected return on assets (EROA). But why might that happen?
“The purpose of a glide path is to systematically capture gains in a plan’s funded status—that is, sell return-seeking investment—while increasing the correlation between the total portfolio and plan liabilities; that is, move assets into LDI investments,” says Smith. “As a plan moves along a glide path, allocations to LDI investments will increase while allocations to return-seeking assets decrease. The movement away from higher expected returning assets into lower returning investments will reduce the overall EROA.
As of Sept. 30, 2021, NEPC’s 10-year forward-looking return expectations for U.S. Large Cap Equity is 5.0% and for Long Credit is 2.8%, Smith notes. “As you can see, allocating more assets to long-duration bonds will reduce the overall expected return for the plan,” he says.
U.S. Large Cap Equity markets have returned 16.2% over the last 10, Smith adds. “During this same period, interest rates declined leading to positive fixed income returns of 6.5% (according to Bloomberg Barclays Long Credit annualized as of Oct. 31, 2021). The strong market performance of the S&P coupled with today’s low-interest rates reduces future return expectations. For example, at Dec. 31, 2020, NEPC’s 5-7 year forward-looking returns for US Large Cap Equity was 7.0% and Long Credit was 5.75%.”
Next: Trends and Looking Ahead
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