Pensions

Dynamic Asset Allocation for Corporate Plans

Plan sponsors implementing a liability-driven investment approach must recognize that they face an asymmetric risk and reward trade-off as a plan's funded ratio approaches 100%. Creating or adding to a surplus position is of limited benefit, whereas unexpected deficits lead to higher contributions. Therefore, increasing the emphasis on liability-matching strategies as the funded ratio improves should be an objective of a dynamic asset allocation strategy.

Plan sponsors must determine their ultimate funding objective:

Active plans can use surplus to offset future benefit accruals, but must weigh this potential benefit against how much risk they can absorb.

Sponsors willing to contribute the full service cost each year in exchange for minimizing possible contribution surprises have little use for surplus, and should transition to a predominantly liability-matching strategy as the funded ratio improves.

Sponsors that want to use surplus returns to reduce future costs might reduce but not eliminate return-seeking exposures at higher funded ratios.

Frozen plans have little use for surplus assets, so one would expect these plans to redeploy return-generating assets into liability-matching strategies as funded ratios approach 100%.

Plan sponsors might find it helpful to use the concept of a utility curve in evaluating how their risk preferences change with changes in the funded ratio. At lower funded ratios, improvements to the funded position are likely to generate large increases in utility. As the funded ratio continues to improve, however, increases in utility will become more marginal.

Read more about mitigating DB plan risk through asset allocation and portfolio construction in "The Defined Benefit Risk/Solution Spectrum."

The Defined Benefit Risk/Solution Spectrum