The Federal Reserve signaling that interest rate cuts will likely come later in 2024 places even more urgency on evaluating the merits of these strategies while interest rates are relatively high.

Plan maturity and investment risk

A pension plan is considered demographically “mature” when it has reached a stage where the number of retirees and beneficiaries receiving benefits is greater than the number of active plan participants. It is natural for a pension plan to mature as participants retire, even if the active participant population remains stable. A declining active population driven by industry changes can accelerate the maturing of a pension plan.

Mature plans generally have negative cash flows, because they are paying out more in benefits than they are receiving in contributions for active participants. In a down market, mature plans must sell assets at a discount to pay benefits, limiting the ability of the assets to recover. A severe downturn — like the Great Recession — can send a highly mature plan on a path toward insolvency, and no reasonable corrective actions can change its course.

Risk-reduction strategies

In the current interest rate environment, pension plan sponsors are implementing various de-risking strategies that align the investment of plan assets with participant benefit liabilities.

Reducing investment volatility

Perhaps the simplest way to reduce risk in the current rate environment is to increase the allocation of plan assets to high-quality fixed income investments. Implementing such a strategy can reduce the overall volatility of the portfolio while maintaining long-term expected returns. In other words, the higher interest rate environment is allowing plan sponsors to reduce risk without sacrificing expected returns.

Liability immunization

Some pension plan sponsors are taking advantage of higher interest rates to “immunize” a portion of their benefit liabilities. This strategy is sometimes referred to as “liability-driven investing.” Under this approach, a plan constructs a dedicated portfolio of high-quality bonds to cover a portion of its projected benefit payments. Effectively, this portion of the benefit liability is immunized and no longer subject to investment volatility or changes in interest rates. For example, a plan sponsor may use this strategy to immunize benefits for some or all current retirees.

Traditional liability immunization tends to be long term in nature, where the portfolio of high-quality bonds is constructed to cover benefit payments for many years, perhaps even the entire expected lifetimes of a group of retirees. Long-term strategies, however, carry a higher risk of default of the underlying bonds or demographic factors, such as increasing retiree longevity. They may also lose some appeal when the yield curve is inverted, (i.e., interest rates on short-term bonds are higher than the rates for long-term bonds).

Short-term, cash flow matching

Short-term, cash flow matching is similar to longer-term immunization in that it involves constructing a portfolio of high-quality bonds to cover projected benefit payments. Under this approach, the bond portfolio is designed to cover benefit payments for the next three to seven years. This strategy is particularly popular among plans that are highly mature or have significantly negative cash flows, including many multiemployer plans that have received special financial assistance under the American Rescue Plan.

Short-term cash flow matching earmarks the next several years of benefit payments and administrative expenses so that the plan does not have to sell assets to meet its liquidity needs. As a result, the plan will be better positioned to weather short-term volatility in the financial markets. The strategy may include mechanisms to extend the cash flow matching portfolio on an opportunistic basis, for example, after a year with strong investment gains or when certain funding thresholds are met.

Pension risk transfers

Some plan sponsors are exploring a pension risk transfer (PRT). Typically, a PRT involves purchasing annuities from a life insurance company to pay lifetime retirement benefits to a selected portion of the participant population. Transferring benefits for retirees can reduce a pension plan’s maturity level. For pension plans subject to ERISA, a PRT will also usually reduce the PBGC premium expense.

Aligning assets and liabilities

When evaluating any strategy aimed at reducing risk, it is important for plan sponsors consider factors such as the plan’s:

• Demographic maturity
• Cash flows
• Current funded status
• Projected funded status

A traditional “assets-only” analysis will not tell the whole story.

For a complete understanding of the impact a new strategy is expected to have on funding objectives, the plan sponsor should coordinate with both its investment consultant and actuary.