DB plans should invest to meet targets set in 2022

Plan sponsors should think about their rationale and primary goals when managing investment portfolios, according to a Willis Towers Watson article.

While the paper discusses investment considerations for both defined benefit (DB) and defined contribution (DC) plans, it indicates that DB plan sponsors need to understand what their performance needs are against goals. desired. “For example, we’ve seen some plans reduce risk too quickly with a sliding trajectory of capital allocation, leaving the plan with insufficient returns needed to meet its goals,” the report said.

Sweta Vaidya, North American head of solutions design at Insight Investment in New York City, says what PD plans should do in 2022 will depend on what happened to the specific plan in 2021. “Many plans have seen their status. capitalization improve, ”she said. . “Whether a plan is open, closed or frozen, all gains made must be protected. “

Vaidya says open plans can likely continue to carry risk, as they will need growth to meet the obligations that continue to accumulate. Yet they are encouraged to take certain risks to protect the funded status.

Funding status means something different for frozen plans than it does for open plans, Vaidya explains. For example, since an open plan will continue to accrue benefits, even if it is 100% funded, it will have to carry some risk. However, the trustees of a frozen plan could likely decide that the plan only needs a 5% cushion on the full funding to protect against volatility. “It would depend on the plan sponsor’s goals as well as cash flow constraints,” she says.

Willis Towers Watson believes that investors need a broader set of yield-seeking opportunities to make portfolios more resilient to an inflationary environment. “Specifically, the uncertain political environment associated with the withdrawal of the stimulus measures, the corresponding rate hikes and the risk of inflation will require careful consideration of traditional portfolios of quality stocks and credits in these scenarios,” he said. declared the company.

For defined benefit plans, rate volatility is expected to impact both liabilities and assets, “credit and treasury bonds are expected to perform poorly due to rising inflation risk premiums and secularly low starting yields, ”said Willis Towers Watson. Plan sponsors need to understand how their existing portfolios will react to different inflation scenarios and identify new sources of income that are generally more resistant to inflation.

In 2022, says Vaidya, it will be important for DB plan sponsors to reduce risk in both fixed income and stocks.

“For growth assets, diversify out of equities because we feel they are overvalued and we expect a correction,” she said. “Plan sponsors should consider real assets, private equity, infrastructure, hedge funds or multi-asset class strategies, as well as private credit. Over the years, we have seen plan sponsors start to look to them.

On the fixed income side of the portfolio, yields are low and the risk of credit migration will add a wrinkle if defaults or downgrades affect assets differently from liabilities, Vaidya says. “It’s hard to perfectly hedge liabilities, but plan sponsors are looking at emerging market debt, structured debt, private debt, fallen angels and bank loans,” she says.

While inflation could be a good thing for corporate DB plans in the United States, as it could reduce costs, the Federal Reserve’s reaction could have an effect on how DB plans should invest. , said Vaidya.

“All other things being equal, it’s probably not a big deal,” she said. “Company DB plans generally do not offer COLA [cost of living adjustments] for retirees, and some plans hold investments in real estate and infrastructure, which will maintain asset growth. But plan sponsors fear the Fed could hike rates quickly, which would dampen returns on fixed-income portfolios. Sponsors will need to review their strategies for managing interest rate risk.

Coping with inflation

Willis Towers Watson says private assets, especially private loans with variable rate coupons, as well as real assets, which have a natural inflationary component, may become more relevant tools for plan sponsors to deal with future pressures. inflationary.

With an annualized inflation rate of over 5% through the end of May in the United States and growing fears of inflation, Morningstar Indexes has studied index returns since the start of 2021. The results suggest that value stocks, commodities, real estate, and inflation-protected treasury securities (TIPS) can act as inflation cushions.

“The past few months have offered a unique opportunity to test the performance of various asset classes in an environment of rising inflation and inflation expectations,” said Dan Lefkovitz, strategist, Morningstar Indexes, Chicago. “Notably, value stocks have responded well to economic growth and a concomitant rise in interest rates. And “real assets” such as commodities and real estate – the traditional inflation hedges – have been true to form. And, on the fixed income side, TIPS is an excellent hedge against inflation, as returns are tied to the US Consumer Price Index. [CPI]. “

“Inflation is having a devastating impact on purchasing power and the current surge in prices is a real-time reminder for investors to always remain vigilant,” said Mark Carlson, senior investment strategist – FlexShares at Northern Trust Asset Management in Chicago. “Maintaining a strategic allocation to real assets such as a wide selection of natural resources, real estate assets and infrastructure has the ability to provide long-term sustainable inflation protection for portfolios. “

Other investment considerations

Willis Towers Watson says the expansion and expansion of DB plan funding relief through the American Rescue Plan Act (APRA) has provided plan sponsors with increased flexibility in pursuing their goals, as the potential for higher contributions has been reduced. He says this could allow some plan sponsors to pursue a more aggressive investment strategy that may ignore some of the bumps in the road that might previously have triggered a cash contribution. On the other hand, plan sponsors looking to take less risk may be content with a longer time horizon on the path to achieving their goal.

But, Vaidya warns, the funding relief could make plan sponsors want to take another risk. “I can see this happening with poorly funded plans, which could reduce the likelihood of reaching fully funded status,” she says.

Willis Towers Watson also suggests that plan sponsors consider active management and higher conviction portfolios that can add value. “The volatility of each manager can be offset by a multi-manager structure, with monitoring against objectives and / or a benchmark occurring at the level of the overall or total structure,” he says.

Specifically, Willis Towers Watson says DB plan sponsors should consider expanding their high conviction investment strategies to potentially return-generating ideas, such as credit and real assets, other than stocks. And the consultant warns plan sponsors not to “lend where it’s crowded.” Instead, assess where you are lending and aim to reduce the risk of business lending, given the overlap with your equity portfolio.

Additionally, Willis Towers Watson suggests that DB plan sponsors consider incorporating investment themes into portfolios, such as environmental, social and governance (ESG) investing. “One area of ​​interest that investors are likely to incorporate into their programs is the management of climate risk and its potential impact on asset returns,” the report says. “Having a more explicit focus on climate risk throughout your portfolio could lead to alpha opportunities and / or more sustainable cash flow. “

On a related note, the consultant says diversity, equity and inclusion (DE&I) has never been a higher priority for the asset management industry. According to the document, the DE&I assessment “requires a holistic assessment that goes beyond the simple examination of the property. We believe that ownership is an easily achievable measure that fails to incorporate diversity between different functions within an organization. We believe that the only way to have more diversified owned investment companies is to first have diversified leadership and investment teams. By measuring diversity at these three levels, we believe that the resulting assessment helps provide a more solid and relevant picture of diversity.

Willis Towers Watson says his beliefs are supported by his research, which shows that more diverse investment teams generate higher returns on investment.

On a final note, Vaidya says there is a risk that plan sponsors will not be prepared. For some, the improvement in funded status came quickly and they adjusted their descent paths, but others don’t have descent paths in place. “Teams in general should ask themselves what their goals are and if they’re ready to move closer to their goals to take action and make changes to their portfolios,” she says.

The full list of issues Willis Towers Watson says pension plan sponsors need to consider in 2022 can be found in his article “Investing with a Goal in 2022”.