In the past few years, there’s been a change in how a large number of U.S. corporate defined benefit (DB) pension plans manage their asset allocation policy. Since those plans in total represent over $3 trillion1 of assets, it’s worth thinking about how this change could affect market behavior.
Liability–responsive asset allocation
Because the sums involved are so large, the shifting patterns of DB plan investment have always been important for markets. In many ways, private DB plans have less of a herd mentality than other investor groups, but one strong trend that is noticeable across the sector as a whole is de–risking: moving out of equities and into bonds.
Notably, plans have increasingly adopted formal de–risking glide paths, which means they have tied asset allocation policy more closely and formally to funded status. We refer to this approach as liability–responsive asset allocation (LRAA) and it’s not something that’s been around all that long. Jim Gannon and I first wrote about it in 2009, and in a newly–published research paper we re–visit the strategy and the important developments that have occurred since then.
LRAA proved to be popular from the very start. Even as early as 2011 (the first half of which saw increases in funded status for many) early adopters were seeing the schedules have an effect. As Jim and I note in the new paper, “The typical U.S. pension plan experienced an improvement in funded status over 2010–2013 of 10–25% (depending on contribution policy and other factors.) Hence, most plans who had adopted LRAA schedules hit a number of trigger points over that period, the result being a general move from return–seeking to liability–matching assets.”2
Since 2013, however, the typical plan has seen little if any improvement in funded status, so trigger points have not been hit as often. If and when the cycle turns and funded status improves, however, the way in which plans respond will be different than in the past because of the widespread adoption of de–risking glide paths. In place of a prolonged process of strategy reviews and implementation, the response can be expected to be relatively quick, and largely similar across many plans.
This is a new thing, and it could mean that the impact on markets of pension plan de–risking is different than in the past.
Probably a stabilizing rather than de–stabilizing strategy
The idea of a large group of investors following similar strategies according to pre–determined rules will ring warning bells for some readers, raising a concern about potential market destabilization.
It is the nature of LRAA, however, that its effect tends to counteract market changes, rather than to accentuate them: it creates negative feedback rather than positive. If, for example, funded status were to improve as a result of a sharp increase in interest rates, this would lead to pension plans buying bonds, which might dampen the interest rate movement; as I noted in a recent post, pension plans are a natural buyer in a bond market sell–off. Alternatively, if the improvement in funded status were to come about as a result of strong equity markets, this would lead to pension plans selling equities; once again tending to mitigate the effect that caused the change in allocation.
Markets are complex things, so we cannot say for sure how their behavior will be changed. But whatever the actual effect of the new approach to de–risking turns out to be, the widespread change in how DB plans will respond to future improvements in funded status is worth noting.
1Source: U.S Federal Reserve Flow of Funds report (December, 2016 release).
2Gannon, J. and B. Collie (2017) “Liability–responsive asset allocation: defining the de–risking glide path for defined benefit pension plans” Russell Investments Viewpoint.