How to synch up your pension status and investment strategy

December 19, 2019

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How to Sync Up Your Pension Status and Investment Strategy

Just as a defined contribution (DC) plan glide path progresses from a young participant focused on asset growth to a retiree concerned with capital preservation, so too should a defined benefit pension plan evolve. Every active pension plan exists in one of three phases: open, closed, or frozen. In an open plan, new employees are enrolled at a point after hire and accumulate benefits with each year of service. A closed plan is not enrolling new participants, but employees already in the pension continue to accumulate benefits. When frozen, a plan no longer enrolls new participants and its existing participants no longer accrue new benefits.

The status of the plan (open, closed, or frozen) greatly impacts its optimal investment strategy. Jim Gannon, senior investment actuary with Vanguard Institutional Advisory Services®, says the majority of corporate pension plans today are either closed or frozen. That's a big shift from the years before the global financial crisis of 2008 when roughly 90 percent of corporate pensions were open. "After the financial crisis, plans went from being near-100 percent funded to around 80 percent funded," he says. "So not only did companies have to find ways to fund the plan back to 100 percent, they had to keep funding the new benefits. That's when a lot of plans decided to close or freeze to make it less expensive to get back to 100 percent."

In an open plan graphic

In an open plan, new employees are allowed to enroll and they accumulate benefits with each year of service.

As a result, an increasing number of corporations shifted the focus of the retirement benefits package offered to employees from pension plans to DC models, shifting much of burden of uncertainty surrounding future retirement expenses from the employer to the employee. Gannon points out, however, that neither of these developments mean that existing pensions have gone away. These plans will continue to exist for as long as there are assets to be invested and participants to be paid. But how a plan sponsor chooses to manage its pension has much to do with which phase it's in.

Adopting a new investment mindset

For instance, in an open plan, a company's liabilities grow because new participants enter the plan every year. Those new participants earn benefits which increase the company's liabilities and therefore assets have to increase to keep pace. "An open, ongoing plan is likely to have a higher percentage allocated to return-seeking assets because it needs to cover the cost of the benefits being earned," Gannon says. That means 50 percent to 70 percent of assets can be in equities, with some even choosing to invest in higher risk options such as private equity and private real estate, he adds.

A closed plan will also want to include return-seeking assets, but not at the level of an open plan. If the closed plan is fully unded, Gannon says an allocation of no more than 30 percent equities is typical. If it's not fully funded, then it will likely need to increase return targets to reduce the funding gap. In that case, the equity allocation will be higher than 30 percent.

At the other end of the spectrum are frozen plans. Because these plans have a finite life span, they need to be managed quite differently. That means there is less emphasis on equities and more on liability-hedging assets such as long duration investment-grade fixed income. Since liabilities aren't growing in a frozen plan, Gannon says the primary objective is to pursue investment strategies that keep the plan well-funded. "With a frozen plan you're looking at an endgame," he says, "whether that's just looking to pay benefits out every year or whether it's to contract with an insurance company and move the pension off the balance sheet of the company."

A closed plan graphic

A closed plan is not enrolling new participants, but employees already in the pension continue to accumulate benefits.

An outsourced chief investment officer (OCIO) can benefit pension plans in all three phases of the life cycle, but for frozen or closed plans an OCIO provides a level of focus and care that can benefit the firm. As a company transitions to a DC plan, it naturally spends more time and resources on managing this benefit and less time on its legacy pension plan. In reality, it's managing two plans—and that's where an OCIO can make a difference, Gannon says.

Frozen plan graphic

When frozen, a plan no longer enrolls new participants and its existing participants no longer accrue new benefits.

For the many pension plans still underfunded, an OCIO can spend the time needed to monitor and implement the glide path—or the process that adjusts the asset allocation from a growth focused equity portfolio to a liability hedging fixed income portfolio—as the plan works its way back to fully funded. Further, with each passing year, the duration, or interest rate sensitivity, profile of the pension liabilities will change and an OCIO will be responsible for monitoring the change's impact on an optimal liability hedging fixed income allocation. As time passes, the duration of the liability shortens and so should the duration of the assets backing those liabilities.

"As the company focuses on the defined contribution plan, an OCIO can make sure that its existing pension obligation is properly managed," Gannon says. "When a plan is frozen, the mindset about asset allocation has to change as well. As we talk to clients with frozen plans, or even those considering closing a plan, we're helping them with the education process. A good OCIO will work to explain how to transition from a growth mindset to a liability-driven mindset so that the plan will have the resources needed to meet its obligations no matter what its status."

Developed in collaboration with CNBC Brand Studio.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Advisory services are provided by Vanguard Institutional Advisory Services® (VIAS), a division of Vanguard Advisers, Inc., a registered investment advisor.