U.S. stock markets are up. Long-term interest rates are up. Corporate defined benefit (DB) plan sponsors have been anticipating this type of market environment for more than a decade. In many instances, sponsors developed a plan (or glide path) to reduce risk as their funded status improved. Those same sponsors may have now moved one phase, two phases or even all the way down their glide path depending on their funding policy.
For sponsors that have made (or are contemplating) glide-path moves but are not yet fully funded, we offer these words of caution: some de-risking can be beneficial, but unless your company has the willingness to fund the liability shortfall, too much de-risking could lead to higher contribution requirements.
When developing a glide path, plan sponsors generally target one of two funded status levels: 100% funding on an accounting (Aa Corporate) basis, or 100% funding on a termination basis. If your glide path was developed to reach full funding on an accounting basis but you have now set your sights on plan termination, you might be in a situation where your portfolio will not be able to generate sufficient excess returns over your liabilities to succeed.
The good news is that there is a relatively simple method to approximate the return needs of your portfolio — the hurdle rate. The hurdle rate is the rate of return needed to maintain your DB plan's surplus/deficit to liabilities. To calculate your hurdle rate, you will need an estimate of your liability return (which incorporates interest rate expectations and benefit accruals) and a recent funded status.
For example, assume that a 100% funded, hard-frozen plan has an estimated liability return of 4%. The hurdle rate would be 4%, because if the liabilities grow by 4% and the assets grow by 4%, the plan's deficit will remain at zero next year.
Unfortunately, a 90% funded plan would not have this same luxury. A 90% funded plan would have a hurdle rate of more than 4.4% compared to the 4% return on the liabilities. Remember, a 4.4% portfolio return only maintains the existing deficit to liabilities. To improve the funded position, the portfolio return must exceed the hurdle rate. If the expected return of your portfolio is less than 50 basis points above the hurdle rate, you may find that additional contributions will be the only way to consistently improve your funded status.
The hurdle rate mentioned above does not incorporate plan management fees, PBGC premiums or potential longevity increases. Incorporation of these elements will usually serve to increase the hurdle rate further.
The rate of return required on plan assets in order to maintain the surplus/deficit to the liabilities of a defined benefit pension plan. Portfolios that earn in excess of the hurdle rate will reduce their funding deficit. Portfolios that fall short of the hurdle rate will see their funding deficits increase (or surpluses decrease).
A term used to describe adopting a more conservative investment strategy. For Corporate DB plans, de-risking can involve the use of liability matching fixed income.
A term used to describe a systematic approach to de-risking a pension plan. Phases of a glide path are developed by the plan sponsor and their advisors and usually involve one or more factors (i.e. funded status, level of interest rates, passage of time, etc.). The sponsor typically sets levels for the underlying factor (i.e. 80%, 90%, 100% funded status). Each time a new level is reached, the plan is de-risked.
Premiums paid by defined benefit plan sponsors to insure payments to beneficiaries in the event the sponsor cannot meet obligation.