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Portfolio design

Pension perspectives: One-way vs. two-way glide paths

Jun 3, 2019
By Belinda Ji, Deepesh Shah, Gabriella Barschdorff, CFA

Many corporate pension plans have embraced a glide path – a rules-based framework that de-risks their portfolio at higher funded ratios. In most cases, plans have adopted a one-way path, which allocates more to liability-hedging assets as the funded ratio rises but does nothing if the ratio falls, as it did for many plans in the volatile period of late 2018.

Testing time

The last quarter of 2018 was a testing time for most pension plans, as a broad-based decline in equities and a fall in bond yields dragged funded status down by 6% on average1. This drop was large enough to erase most of the previous gains of 2018. Toward year end there was a healthy debate over whether this was the beginning of a drawn-out downturn, or a temporary blip. The subsequent V-shaped recovery in equities ignited interest in best practices around one-way versus two-way glide paths. For our pension clients, we re-underwrote the portfolio and glide path construction in light of current market conditions and lower funded ratios. In most cases we decided to stay the course, but for certain plans re-risking made more sense. In this paper we evaluate which strategy might work better in aggregate and outline some of the relevant considerations for plan sponsors.

1 The following asset class weights, as of January 31, 2019, are based on the aggregated asset allocations on 12/31/2015 of the largest 100 US defined benefit pension plans of publicly-traded US corporations: Bloomberg Barclays Long Government/Credit Bond Index 21%, Bloomberg Barclays Aggregate Bond Index 21%, MSCI ACWI 37%, S&P Listed Private Equity Index 6%, HFRX Global Hedge Fund Index 6%, Dow Jones U.S. Real Estate Index 5%, Bloomberg Barclays 1-3 Month T-Bill Index 4%. Source: Pensions & Investments. No allowance has been made for active management or costs. Asset returns are based on the historical levels of the modeled indices below. Liability returns are based on the historical levels of the Bank of America Merrill Lynch Mature US Pension Plan AAA-A Index. Expected liability volatility modeled as the Bloomberg Barclays Long Corporate High Quality Index. The assumed beginning-of-2016 funded ratio is based on the average reported funding ratio of the 236 DB plans sponsored by S&P500 companies, as of 12/31/2015.

To re-risk or not to re-risk?

Which strategy works better to improve the funded ratio is seemingly a basic question, but one that is very hard to provide a general answer to. We find that the verdict is highly dependent on the time period analyzed, the starting allocation, the triggers that are used for de-risking, and the rebalancing frequency. We do, however, conclude that two-way glide paths will only work with frequent oversight and the strong governance model found on high-touch outsourced CIO platforms. And even then, plans would need to be comfortable with taking deliberate steps to increase portfolio risk in the most volatile markets.

Required portfolio return to reach full funding

In our work managing discretionary pension portfolios, we review the strategic asset allocation and glide path annually as the liability cash flows are updated. The various components of the liability growth rate, PBGC fees, and benefit payment drag are inputs into computing the required rate of return (hurdle rate) to reach funding goals. In Exhibit 1 we show the hurdle rates for three different starting funded ratios and see that a 70% funded plan needs a 10.8% annual return while a 90% funded plan needs only a 6.1% return to reach the same goal.

Exhibit 1: Hurdle rate for pension plans to reach 100% funded in ten years

Exhibit 1: chart showing hurdle rate for pension plans to reach 100% funded in ten years.

Source: BlackRock, as of March 31, 2019. Interest cost is equivalent to the liability yield. PBGC cost is the estimated fixed and variable rate premiums for a typical plan. Benefit payment drag is the result of benefits payments impacting the assets and liability in funded ratio percentage terms. Deficit reduction is the extra return required for an underfunded plan to move to fully funded status. The combined hurdle rate is the required asset growth that would enable a plan to close its funding gap over ten years. The 80/20 portfolio is represented by 80% MSCI ACWI, 10% Bloomberg Barclays Long Government and 10% Bloomberg Barclays Long Credit. The 50/50 portfolio is represented by 50% MSCI ACWI, 25% Bloomberg Barclays Long Government and 25% Bloomberg Barclays Long Credit. Expected returns are calculated using Aladdin Risk Model and are based on BlackRock’s February 2019 capital market assumptions (see appendix). Expected return estimates are subject to uncertainty and error. Expected returns for each asset class can be conditional on economic scenarios; in the event a particular scenario comes to pass, actual returns could be significantly higher or lower than forecasted. Indexes are unmanaged and it is not possible to invest directly in an index.

Market-driven drawdown: Hindsight is always 20/20

So if funding levels fall as they did in late 2018, should a plan re-risk to increase the chance of recovery? After all, a larger funding shortfall means that more return is needed to reach the same funding goal – suggesting a two-way glide path is preferable. However, whether re-risking ends up being the right choice will be highly dependent on subsequent market moves, which of course are unknown at the decision time.

The most recent period of market volatility, from the fourth quarter of 2018 into the beginning of 2019, turned out to be fairly short-lived. In Exhibit 2 we show what the experience would have been for a typical plan that chose to re-risk (two-way glide path, yellow line) versus a plan that simply rebalanced back to the strategic weights (one-way glide path, orange line). We find that re-risking at the end of 2018 resulted in temporarily slightly stronger funded status, but it would have been critical to time the re-balancing exactly right in order to capture those gains.

Exhibit 2: Funded ratios for one-way vs. two-way glide paths, November 2018 – March 2019

Exhibit 2: Chart showing funded ratios for one-way vs. two-way glide paths, Nov 2018 – Mar 2019.

Source: BlackRock and Bloomberg, as of March 31, 2019. For both glide paths we assume a plan with an 80% funded status and a starting allocation of 42% MSCI USA Index, 18% MSCI World ex-US Index, 20% BBG Barclays Long Credit Index, and 20% BBG Barclays Government Index. The liability is represented by the BBG Barclays Long Credit Index. We assume no service accrual, benefit payments, contributions or other non-market impact on the asset or liability values. The two-way glide path rebalances weekly in accordance with the glide path in the Appendix, while the one-way glide path rebalances monthly. Indexes are unmanaged and it is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Beware of the volatility

Looking at history over almost any long-enough time frame, equity markets have tended to recover, suggesting that long-term investors should benefit from re-risking in downturns. However, we find that in practice that long-term approach can lead to more volatility and discomfort than many plan sponsors can tolerate. In order to successfully execute a two-way glide path, plans would need to rebalance into equities as markets are tumbling. This would need to occur at the same time that the plan reports its financial health in accounting statements, with a negative impact from larger deficits and higher pension expenses when a corporation can least afford it.

Also, the cost of selling investment grade long credit—as in this example—in order to buy equities can be compromised during times of market volatility, working as a real-world implementation constraint.

In Exhibit 3 we show the experience during the 2008 financial crisis and recovery for a plan that chose to re-risk (two-way glide path, yellow line) versus a plan that simply rebalanced back to the strategic weights (one-way glide path, orange line). The two-way strategy would have remained at the maximum allocation to growth (80% equities / 20% hedging) for much of this period, experiencing sharp swings in funded status as a result. Toward the end of the period, there is no material difference between the two strategies.

Exhibit 3: Funded ratios for one-way vs. two-way glide paths during the financial crisis, September 2008 – March 2010

Funded ratios for one-way vs. two-way glide paths during the financial crisis, Sep 2008 – Mar 2010

Source: BlackRock and Bloomberg, as of March 31, 2019. For both glide paths we assume a plan with an 80% funded status and a starting allocation of 42% MSCI USA Index, 18% MSCI World ex-US Index, 20% BBG Barclays Long Credit Index, and 20% BBG Barclays Government Index. The liability is represented by the BBG Barclays Long Credit Index. We assume no service accrual, benefit payments, contributions or other non-market impact on the asset or liability values. The two-way glide path rebalances weekly in accordance with the glide path in the Appendix, while the one-way glide path rebalances monthly. Indexes are unmanaged and it is not possible to invest directly in an index. Past performance is not a guarantee of future results.

Factors to consider in glide path design

Each plan’s unique circumstances will also play a role in determining whether a one-way or a two-way is the right glide path strategy. We highlight four specific areas for a pension plan to consider.

Pension plan governance model: The monitoring of funded status and the rebalancing process are important real-world considerations in managing a glide path. We find the ideal way to execute any glide path is with daily monitoring and swift decision-making, not the typical governance model for pension investment committees. Case in point: The optimal day for re-risking during the fourth quarter of 2018 was December 24 – a day when likely very few investment committees convened to discuss and make decisions on pension investments.

Plan sponsor risk appetite: The level of risk aversion varies from plan to plan and is heavily influenced by factors such as materiality of the plan relative to the sponsor and approach to company contributions. For plans with higher risk appetite, and the stomach to buy equities in falling markets, a two-way glide path may be worthwhile.

Return-orientation of the portfolio: Pension portfolios that are less well funded and at the beginning steps of the glide path tend to have higher return hurdles, which tend to coincide with longer investment horizons. These companies may be rewarded for re-risking in market drawdowns as they can essentially buy the dip and wait it out.

Change in liability structure: Longevity improvements or risk transfer events, among other changes to liability structure, are more structural reasons for funded status decline, and are unrelated to market dynamics. In these situations, we would be more inclined to recommend re-risking the portfolio.

Overall, we believe one-way glide paths remain the reasonable default choice for most pension plans given the asymmetric relationship between risk and reward, the potential of re-introducing behavioral issues of market timing, and the implementation issues that are introduced in trading during periods of market volatility. Two-way glide paths are a reasonable choice to consider for plans with a greater return orientation and a strong governance model, with the ability to implement changes in the portfolio in a timely manner.

Appendix

Appendix chart

Source: BlackRock, as of March 31, 2019. For both glide paths we assume a growth allocation of 70% MSCI USA Index, 30% MSCI World ex-US, 50% BBG Barclays Long Credit, and 50% BBG Barclays Government. The liability is represented by the BBG Barclays Long Credit Index. Indexes are unmanaged and it is not possible to invest directly in an index.

Appendix table

Source: BlackRock Investment Institute, April 2019. Data as of 28 February, 2019. Notes: Return assumptions are total nominal returns. US dollar return expectations for all asset classes are shown in unhedged terms, with the exception of global ex-US Treasuries, hedge funds and global large cap equities. Our CMAs generate market, or beta, geometric return expectations. Asset return expectations are gross of fees. We use long-term volatility assumptions. We break down each asset class into factor exposures and analyse those factors' historical volatilities and correlations over the past 18 years. We combine the historical volatilities with the current factor makeup of each asset class to arrive at our forward-looking assumptions. This approach takes into account how asset classes evolve over time. Example: Some fixed income indices are of shorter or longer duration than they were in the past. Our forward-looking assumptions reflect these changes, whereas a volatility calculation based only on historical monthly index returns would fail to capture the shifts. We have created BlackRock proxies to represent asset classes where historical data is either lacking or of poor quality. Expected return estimates are subject to uncertainty and error. Expected returns for each asset class can be conditional on economic scenarios; in the event a particular scenario comes to pass, actual returns could be significantly higher or lower than forecasted.

Gabriella Barschdorff, CFA
Co-Head of Americas Pensions team within Client Portfolio Solutions
Gabriella Barschdorff, CFA, is a member of the Americas Client Portfolio Solutions team within BlackRock.
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Deepesh Shah
Associate, Americas Pensions team within Client Portfolio Solutions
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Belinda Ji
Analyst, Americas Pensions team within Client Portfolio Solutions
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