Pension funded status risk: Perception versus reality

Plan sponsors report that they’ve taken significant steps to manage risk: They’ve adjusted plan designs, lengthened fixed income durations, adopted glide-path strategies to increase fixed income allocations, and transferred liabilities to plan participants and insurance companies.

But our survey and conversations with pension plan sponsors reveal that sponsors have severely underestimated the asset/liability risk—also known as the funded status risk—in their plans. As Jim Gannon, Vanguard senior investment strategist and lead actuary, explains, “Our survey shows that most plans have an asset allocation with a risk of more than 20%, meaning that a fully funded pension plan could fall to 80% funded in one year. But most plan sponsors thought their risk was 10% or less, which means they haven’t budgeted for a 20% drop in assets relative to liabilities because they don’t think it could happen.” 

Although 91% of survey respondents said that only a 10% downside variation is acceptable, just 16% of plan sponsors have adopted an asset allocation strategy that aligns with that risk level,¹ as the chart shows. “The most important consideration in adopting an asset allocation,” says Vanguard Senior Investment Consultant Valerie Dion, “is understanding the range of future outcomes and whether the plan can withstand that range. If the plan can’t withstand that variation, the allocation is probably too aggressive.”

Given the discrepancy between their stated risk tolerance and the possible variation associated with their asset allocation, plan sponsors are faced with a vexing question: Should they adjust their risk tolerance or their asset allocation?

On the one hand, the plan sponsor and investment committee could keep their risk tolerance unchanged and shift their asset allocation from return-seeking assets to liability-hedging fixed income assets. Such a move would lower the plan’s funded status risk.

Or they could keep their portfolios unchanged and adjust their risk tolerance, accepting the additional downside funded status risk in exchange for the potential of higher equity returns. Then they could factor that adjusted risk tolerance into the range of possible outcomes. 

Notes: 

• All investing is subject to risk, including the possible loss of the money you invest. 
• Diversification does not ensure a profit or protect against a loss.