How did pension glidepaths impact pension plan outcomes?

In March of 2020 we saw a significant downturn in the equity markets only to see an incredible recovery during the remainder of the year.  Interest rates plummeted and remained low throughout the year.  These economic changes resulted in material funding level volatility for pension plan sponsors, especially corporate pension plan sponsors.  In this article we evaluate the effects of different asset allocation “glidepaths” typically employed by corporate pension plan sponsors and how they fared during 2020.  These glidepaths are designed to help sponsors reduce the volatility of their funded status as funded status improves.

For this analysis we assume three different glidepath strategies, applied to a pension plan that started 2020 at 85% funded. We hold items like benefit payments and contributions consistent throughout the period to limit the number of competing factors.

Our starting glidepath, Strategy 1, is the one shown below in figure 1.  This strategy reduces the amount of the growth portfolio (mainly equities) and increases the amount of liability matching assets (mainly long-term bonds) in the asset allocation as the plan’s funded status grows. For Strategy 1, we also assume that the portfolio’s allocation only changes as a plan’s funded status increases. The plan does not re-risk (i.e., increase growth assets/reduce liability matching assets) if the funded status declines.

The second glidepath we simulate, Strategy 2, is the same as Strategy 1 but allows for re-risking if the funded level falls.  The difference between the two strategies allows us to see the potential benefit of re-risking. Both Strategy 1 and 2 started the simulation with a 50% allocation to growth assets and a 50% allocation to liability matching assets.

Strategy 3 replaces traditional growth assets with equity derivatives in a strategy referred to as Structured Equity. The equity derivatives allocation shapes returns as shown in Figure 2. The plan’s asset allocation is 100% liability matching fixed income, and the exposure to equity markets obtained using derivatives is in addition to this. The notional of the equity derivatives exposure remains constant. The amount of equity market exposure is determined based on the beginning of year funded status, and for this analysis we start with a 50% equity allocation.

The graph below shows a plan that was 85% funded as of January 1, 2020.  The results shown are similar for different starting funding levels.

Given the fall in equity markets, all portfolios decline in funded status through March. Strategy 3 dampened the fall because it provides protection for the first 15% of market declines. Strategy 2 re-risked at the end of March whereas Strategy 1 kept the same allocation. Re-risking proved to be beneficial for the remainder of the year as equity markets soared in Q4. Strategy 3 dampened much of the volatility and benefitted from more fixed income assets, but had its upside capped by year-end due to the way that equity exposure is obtained (forgoing some potential upside for downside protection).

This analysis assumed action taken at the end of each month in terms of re-risking or evaluation of the glidepath.  Additional value could have been generated from daily monitoring or detracted by less frequent monitoring than monthly. In addition, this analysis includes no manager alpha. Some managers may have improved results, and a good derivatives manager might have “reshaped” the equity exposure prior to December.

For 2020, having the ability to re-risk on a glidepath would have proven worthwhile. The benefit of re-risking into equities at the end of March would have been greater, but corporate bond assets, which were also depressed in price, would have been sold to fund that re-risking.  Having greater exposure to long dated fixed income assets would have dampened the volatility throughout the year.

Even though our three hypothetical portfolios all started and ended around the same place, it’s clear that Strategy 3 did so with the least amount of volatility while Strategy 2 benefitted from re-risking. With 2020 hindsight, plan sponsors should continue to assess what glidepath helps them achieve their funding goals most effectively and efficiently.

Tom Cassara is a Managing Director in River and Mercantile’s New York City office and is the head of the US business.

Elliott Brewer is a Senior Investment Analyst in River and Mercantile’s Boston office.