The idea that pension plan asset allocation should be tied to funded status is surprisingly young. It was not common practice before 2008: when Jim Gannon and I wrote our paper on liability-responsive asset allocation in April, 2009, it was (as far as we are aware) the first time this approach was formally described in any detail.
Today, it’s taken as a given. Nobody is surprised when the financial statements of major corporations talk of “a broad global pension de-risking strategy” or note that “the interest rate hedge is dynamically increased as funded status improves.” (Those statements are taken from the latest 10-Ks of Ford and United Technologies respectively.¹)
To see why this link has become so strong, so quickly, let’s start with this diagram of four basic combinations of investment policy and funding strength.
One big change among pension plans in recent years is that more and more have frozen new benefit accruals. For a frozen plan, investment return becomes less important once full funding is achieved: if there’s already enough money in the plan and there are no new benefits being accrued, then there’s not much to do with any additional returns that might be earned. (The obvious route—returning them to the plan sponsor—comes with a hefty tax bill attached.) Hard evidence of the importance of the trend toward freezing is offered in a recent survey by the magazine aiCIO: among the 119 respondents, more than 80% of closed and frozen plans had a de-risking glide path in place, compared to less than 60% of open plans. So—for frozen plans at least—a strong funding position can rule out a return-oriented investment strategy; there’s not enough potential benefit to make the risk worthwhile. This knocks out the upper right quadrant in our diagram.
The bottom left, meanwhile, represents an underfunded position with a cautious investment strategy. The question in that situation is: where is the money going to come from to make up the shortfall? Pension plans only have two ways of raising money: contributions from the plan sponsor and returns earned on the existing assets. And if the money is coming from plan sponsor contributions, it’s generally better to make those contributions sooner rather than later: this is a consequence of recent increases to PBGC variable rate premiums. Those premiums are fast getting to a level where a plan sponsor would need to have an extraordinarily high cost of capital for it to make sense to delay contributions. So the bottom left quadrant is knocked out, too.
With two of the quadrants ruled out of consideration, two choices remain. One is the top left quadrant (funding shortfall; return-oriented strategy); this is where many plans are today. But where they want to be, and where they are headed, is the bottom right (strong funding; low risk); that’s the targeted end game.
And that, in short, is why the funding and investment policy decisions have become completely interdependent for many corporations.