Implementing and optimizing your de-risking strategy: Q&A with RiskFirst’s Michael Carse

In the U.S., market factors are converging to make pension risk transfer more attractive than ever. Here’s a Q&A with Michael Carse, DB Pensions Product Manager, RiskFirst, about some of the drivers of de-risking for U.S. plans, what constitutes best practice for implementation, and how technology can support plans as they seek to implement complex solutions.

Q: What market factors in the U.S. are currently shaping pension plans’ de-risking decisions? MC: While any de-risking decision should take into account a pension plan’s specific situation, there are three key market factors currently at play that will have an influence: strong recent performance in equity markets – notwithstanding recent volatility – legislative reform in tax and accounting, and reducing variable-rate PBGC premiums. All of these provide a catalyst for plan sponsors to actively revisit their de-risking strategies.

Expanding on these factors a little, the 2018 plan year is the last opportunity to maximize a pension plan’s tax deduction before the lower corporate tax rate comes into force, which may lead to substantial contributions – thereby improving plans’ funded positions and creating opportunities for investment.

Meanwhile, changes to the accounting model are coming into force. Whereas pension risk transfer strategies have previously triggered settlement accounting with a negative impact on a sponsor’s operating income, this will instead be included in non-operating expenses going forward. This could therefore help to make de-risking more attractive for plan sponsors.

Finally, equity markets – the traditional solution for pension plans – have continued to perform very strongly. General improvements in funded status create opportunities for asset allocation changes, increasing a plan’s interest rate and credit hedge ratios.

Q: If a plan assesses these factors and decides to act, what are the next steps? This will depend upon what has specifically been decided, the reason behind the decision and whether this is more tactical or strategic.

For example, if tax reform is driving an injection of contributions, plan sponsors first and foremost need to think about where that money will be invested. The simple answer is: in line with an existing benchmark.

But plans should rather see this as an opportunity to take stock and reassess the design of the liability hedging portfolio.

Plans looking to complete some type of pension risk transfer will need to consider multiple viewpoints. In the immediate term, a portion of plan assets used to back the risk transfer will most likely need to be held in short-term liquid assets.

Once the dust has settled on the risk transfer, the remaining liabilities may have significantly changed in character, meaning a thorough review of the plan’s asset allocation and particularly its hedge portfolio will be necessary.

Monitoring projected plan funded status along with PBGC premium and contributions will also be important as typically PPA and PBGC funding levels will decrease as a direct consequence of such transfers.

Q: How important is it to have clear glide path designs? In circumstances where a pension plan has made a strategic commitment to de-risking and wishes to do this over time, taking opportunities to reduce risk as and when they arise, it is sensible to have a glidepath plan with targeted LDI portfolios at given points in time.

Many glide paths will employ trigger-based de-risking strategies – enabling plans to alter asset allocations and affordably reduce risk positions when markets are favorable. For example, within a hedging portfolio, market-based triggers can be implemented that aim to gradually reduce interest rate and credit risk as opportunities arise over time.

The ability to monitor plans’ funding positions on a daily basis, and be alerted when triggers have been breached, enables timely asset allocation analysis to be conducted, and can be particularly beneficial to those seeking to understand and react faster – and with more confidence – to moves in the market. This is especially important given the volatility in rates. Monitoring on a daily basis can thereby increase the potential number of opportunities to take action to help optimize plan performance.

Q: We hear a lot about optimizing de-risking strategies, but what does this really mean? Optimizing a de-risking strategy means different things to different people. For some, it is having some notion of optimal timing in the implementation of the strategy. Trigger-based strategies that rely on accurate daily tracking of funded status for different liability measures, liability discount rates and bond yields can help with this.

Beyond timing, an optimization algorithm can be used to determine the optimal hedging portfolio from an interest rate and credit perspective, while achieving a desired portfolio return through a diversified growth portfolio.

This tactical portfolio construction should then be combined with analyzing longer-term projections that help to understand a plan’s ultimate net cost to the sponsor (total contributions and PBGC premiums through time) and the smoothness of the journey (e.g. tracking error).

With new developments creating shifts in the market, this is presenting new opportunities and raising the question of whether to de-risk for many pension plans. The decision of whether or not to de-risk can be complex, but having the tools in place to effectively navigate and understand the market can help to ensure plans make the optimal choice for them, and provide value-added capabilities for the implementation of their de-risking strategies.

Q: How else can technology help? Technology can significantly enhance the effectiveness of risk-aware investment strategies – by helping to construct an optimal duration hedged or cashflow-matched investment portfolio through providing up-to-date, granular information across both sides of the balance sheet.

With this information, plans can create better matched portfolios to the plan’s liabilities, test portfolio solutions from multiple perspectives and optimize performance targeting within an agreed risk framework.

Modern platforms can be used to examine ways in which a plan could maintain a reasonable rate of return while increasing its hedge ratio – using assets more efficiently to generate similar or better results.

Such capabilities can illustrate the trade-off in an easy to understand form between a higher hedge ratio and the impact on returns, while also highlighting the impact from a contribution risk stand-point. Such analysis can not only be performed efficiently, it can be modified and re-run on demand at speed, facilitating live discussions around solutions.

Michael Carse is DB Pensions Product Manager at RiskFirst.