With the rapid growth in funded ratios over the past year, a growing number of US corporate defined benefit (DB) plans have been contemplating their investment approach for the “end state” — the point at which a plan moves from being underfunded to being fully funded or even having a surplus. Once a plan arrives at the end state, its goal will typically transition from improving its funded ratio to maintaining (or spending down) its surplus.

This transition has a number of investment implications, which we explore in this paper through a hypothetical case study. We begin with the process of setting an objective for the surplus return, our preferred return metric for the end state. We then consider how to align a plan’s asset allocation with that objective.

Among our key conclusions:

• Return-seeking assets are still likely to play a role in the investment strategy at the end state, and diversifying those assets can help balance different end-state goals (page 3 of PDF available below).
  
• The majority of assets will likely be in the liability-hedging allocation, and differences in this allocation can have a large impact on volatility, making thoughtful portfolio construction essential (page 6). Plan sponsors may also want to consider alternatives to corporate bonds (e.g., long-duration securitized assets), either to mitigate risk or to seek surplus-return objectives (page 9).
• Some plans in the end state may be surprised to find they have the ability to be a long-term liquidity provider, opening up a role for less-liquid asset classes or a cash-flow-driven investment (CDI) approach (page 9).

Finally, we conclude with our views on the evolution of the glidepath during the end state and, recognizing that some plans are contemplating whether an annuity buyout should be part of their end-state strategy, on developing a lower-risk investment strategy that may be a viable alternative to a buyout.

Setting a surplus-return objective

We began our case study with the assumptions shown in  Figure 1. We assume our hypothetical plan is a frozen plan and, therefore, that there are no new benefit accruals. However, the plan is paying expenses (e.g., PBGC premiums, actuarial, and legal fees) out of plan assets, amounting to 0.35% of the liability. The plan’s objectives are to continue to pay those expenses, maintain the current surplus, and limit the risk of falling back into an underfunded position. (Open plans that aim to cover service cost accruals via investment returns would follow a similar framework but add the ratio of service cost to liability to the plan’s expenses. Please see the glidepath section on page 10 for additional thoughts.)

Next, we translated the plan’s objectives into dollar terms. Beginning with the plan’s $100,000 liability, we assumed a liability return of 3.8% (based on our Investment Strategy Group’s capital market assumptions; see related details and assumptions at the end of the paper), giving us liability growth of $3,800 over one year. Combining that with the $350 in plan expenses (0.35%), we were left with the sum of $4,150, which represents the asset growth (net of investment expenses and fees) the plan will require to maintain its current surplus level.

We then divided that target dollar return ($4,150) by the plan’s total assets ($105,000), which gave us the rate of return required to keep up with the liability growth plus expenses: 3.95%, as shown in the dark blue bars in Figure 2 (Plan B). Of course, a less-well-funded plan would have a higher required rate of return (Plan A) and a better-funded plan (Plan C) would have a lower required rate of return.

Plan sponsors are conditioned to think in liability-relative terms, so we have also included the required funded-ratio return (light blue bars), which is simply the difference between the required asset return and the projected liability return. But while the funded-ratio return is an important metric when the objective is growing a plan’s funded ratio, we think that when the objective shifts to…