Often the focus of Defined Benefit (DB) Plans is on the return generated by the plan assets. The DB assets are managed to provide an attractive rate of return which usually requires a significant allocation to equities or other forms of risk-seeking assets in order to minimize the annual contribution by the sponsor. This approach works well if the risk-seeking assets produce a positive return. Sadly, this isn’t always the case. If risk-seeking assets decrease in value, the DB Plan’s funding status will likely decline which can result in volatile contributions from the sponsor. In years like 2008, when the S&P 500 plunged 37%, sponsors were shocked to see the impact on the plan’s funding status. There is a different way to think about managing a DB plan that focuses on the plan liabilities first and assets second. Asset Liability Immunization Strategy (ALIS) is such an approach.
"There is a different way to think about managing a DB plan that focuses on the plan liabilities first and assets second. Asset Liability Immunization Strategy (ALIS) is such an approach."
What is ALIS?
ALIS is a more robust strategy to manage pension plan assets which focuses on the relationship between plan liabilities and the plan assets. The concept of immunization was developed by a British actuary many decades ago and it focused on matching the duration of the assets to the duration of the liabilities so changes in interest rates have a minimal impact on the market value of the portfolio. This is the basis for ALIS. Plan assets (the portion allocated to fixed-income securities) are managed so their duration matches the duration of the liabilities as provided by the plan’s actuary.
The relationship between the targeted actuarial rate of return and the potential return of the portfolio needs to be considered before implementation of ALIS. If the long-term expected return of the portfolio needs to be lowered due to the reduction in portfolio risk or lower market expectations, a de-link may be created relative to the assumed actuarial return. This may result in a lower expected return which can have a negative financial impact on the plan’s funding rate and required contributions. This relationship is analyzed in the asset/liability study with the results being an important input into the development of the ALIS.
Another key concept of ALIS is the Glidepath shown in Figure 1. The Glidepath determines asset allocation guidelines over time depending on the funded status of the plan as well as the risk tolerance of the sponsor. When a plan is approaching a fully funded status, an opportunity exists to reduce the volatility of the funded status by reducing the allocation to risk-seeking assets. In practice this frequently involves reducing the plan’s exposure to equities and increasing assets invested in fixed-income securities. Risk-seeking assets are needed, especially if the plan is open, so it’s unlikely they would ever fall to zero. Liabilities are grouped into maturity (duration) tranches and constructed so that the duration of each liability tranche is matched by a similar duration of fixed-income assets. The liabilities are never perfectly matched, but this technique provides a very close approximation.
“The Glidepath determines asset allocation guidelines over time depending on the funded status of the plan as well as the risk tolerance of the sponsor.”
Figure 1. Sample Glidepath
Why Should I Use ALIS?
ALIS is a risk management strategy which allows for a reduction in the volatility of the funded status by systematically making changes to the asset allocation of the plan as the funded status improves. A plan that has 60% of the assets allocated to risk-seeking assets has a much greater standard deviation in expected return than a plan with 30% allocated to risk-seeking assets. Actively monitoring the funded status gives the asset manager the information needed to adjust the assets to more-closely match the liabilities. Figure 2 shows that the volatility of the employer contributions declines as the percentage of the investments in the plan are actively hedged against the plan liabilities.
Figure 2. Employer Contribution Volatility
One of the greatest risks to a defined benefit plan is a shortfall in funding. Many plans saw the funded status plunge in 2008. Fast forward to today, if your plan is above the maximum funding level, the surplus may become stranded, yet the downside risk remains resulting in an asymmetrical risk profile. While there is no perfect hedge, ALIS provides a systematic approach to managing the assets in the plan to hedge the liabilities. This requires a change in mindset where the liabilities dictate the structure of the assets.
In Summary, ALIS:
- Focuses on the relationship between cash flows of the plan liabilities and assets to minimize unexpected negative changes to the funded status caused by changes in interest rates.
- Utilizes a strategic investment glidepath designed to decrease the volatility of the employer’s contributions over time by systematically aligning the investment portfolio to the plan liabilities.
- Provides plan sponsors with a strategic and logical approach to managing the DB Plan’s liabilities and funding.
Let Advanced Capital Group help you to more effectively manage your pension plan by utilizing ALIS.