De-risking Part II
Eighteen months ago I wrote a commentary on the subject of de-risking. I was careful to remind clients that we do not give investment advice. I was also careful not to suggest that the de-risking trend that was growing in popularity was the ‘smart’ choice. I was careful for two reasons, first, investment policy is a choice and any policy can be a winner or a loser compared to an alternate policy depending what happens in the markets. Second, I personally believed that too many had jumped on the de-risking bandwagon without having really thought through their goals and risk tolerances.
With that said what I was trying to convey was the importance of having an investment policy that is properly framed in terms of return goals and risk constraints. When I came into this business in the 1980s it was assumed for most small and mid-size plan sponsors that a 60/40 equity/bond balanced fund would properly balance maximizing return within a reasonable level of volatility (risk). As time passed, risk profiles changed, but the investment policies often did not. The early 2000s brought a few rounds of wake up calls and 2008 brought a third hard blow to the risk takers – whether they were knowingly or unknowingly taking those risks. Following 2008 many sponsors hurried to de-risk while others stayed ‘risk on’ either as a commitment to a well founded philosophy that equities would out-perform bonds, or in desperation to make back losses without having to pay for those losses entirely through increased special payments.
Eighteen months later, equities have performed well and bond yields have decreased slightly. Sponsors that stayed invested in equities have been rewarded. But before we throw a party for these sage investors, let’s ask the difficult question of “now what?” Is now the time to de-risk? Can equities keep going? Will bond yields start to rise again, fall, or just stay flat? As has been said many times before, if I knew how to answer these questions I would be on a beach somewhere and not at my desk trying to help clients manage their pension programs.
My first piece of advice is for sponsors to clearly articulate their strategy for the DB benefit promise. Are they committed to DB long-term? Have they closed the plan to new members starting a 20 to 40 year process of getting out of DB? Have they frozen accruals completely for all members – a strategy which offers the opportunity to significantly shorten the horizon for managing DB promises? The bottom line is that if a sponsor is planning to get out of the DB business, then they need to have some clarity on when they hope to do that completely. Sooner or later, exiting a DB plan ends in a wind-up with a liquidation of all investments.
Once a sponsor is clear on its timelines, it can then think more critically about investment risk and reward. Is there any point in growing a surplus if there is no desire to provide new benefits or improve existing benefits? On the other side, what is the cost to the sponsor if investment losses unfold? Are losses to be spread over long periods or do they need to be funded by the sponsor so that the plan can be wound-up before the CFO retires in seven years?
We don’t have easy answers for these questions but they are questions that sponsors should be thinking about. There are many capable investment advisors to help sponsors with these questions and there are a number of asset managers offering de-risking products that work on a ‘glide path’ methodology. These glide path methodologies often trigger automatic de-risking as the funded status improves such that the sponsor need only make one strategic decision and then let the asset manager take it from there. For our part, we are providing some of our clients with quarterly estimates of their wind-up position so that they can monitor the volatility of their investment strategy and so that they can make timely and informed decisions about moving down the de-risking continuum. We are happy to work with sponsors and their investment advisors on these questions. What is important to us is that the questions are being considered and that plans aren’t on remote control with investment policies made decades ago.