Introduction
The majority of corporate defined benefit pension plans have by now adopted a glide path – a rules-based framework that directly ties the asset allocation to funded ratios. In most cases, plans have what we call a “one-way glide path”: investing more in liability-hedging assets as funded ratios rise, but not automatically decreasing hedging if funded ratios drop. In light of well understood and time-tested notions of “buy low / sell high”, one of the most frequent questions we hear from clients is whether a one-way glide path or a two-way glide path leads to better outcomes.
To re-risk or not to re-risk?
Which strategy works better is a basic question, but one that is very hard to provide a general answer. We find that the answer can be dependent on the time period analyzed, the starting allocation, the sizing of the triggers that are used for de-risking, and the rebalancing frequency. Based on our analysis, we recommend that two-way glide paths should be considered for plans that:
- Are comfortable with some short-term drawdowns
- Place a premium on reaching full funding
- Have shifting liability profiles including open benefit accrual, partial plan terminations, and lump sum programs that sometimes can lead to surprise drops in funded ratios
To investigate further, we looked at three different glide path designs, with different asset allocation responses to changes in the funded ratio:
Factors to consider in glide path design
Which type of glide path is best suited to each pension plan is likely to be influenced by each plan’s unique circumstances, in particular where they fall on the familiar risk-return spectrum:
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. For plans with higher risk appetite, and the stomach to buy equities in falling markets, a two-way glide path may be worthwhile.
Return needs: Pension portfolios that are less well funded and have fast-growing liabilities naturally need more return and are typically more long-term oriented. These companies may be rewarded for re-risking in market drawdowns as they are better placed to essentially “buy the dip” and wait it out.
Testing various market regimes
In this section we analyze different market regimes to assess which design is better. We start with a historical view looking back to the last 18 years. In the example below we show the funded ratio of a hypothetical pension portfolio starting at 90% funded in 2006. As is evident from the chart below, there is a no difference in the end outcome: both designs end at ~110% funded. However, the two-way glide path experiences larger drawdowns and more volatility, particularly during the 2008 financial crisis.
Source: BlackRock, as of Jan 2024. Based on ex-post simulated outcomes. Historical period spans 1/31/2006 – 12/31/2023. Hypothetical returns are not a guarantee of future results. Hypothetical results are for illustrative purposes only and do not constitute actual results. Results are based upon model assumptions and are subject to significant limitations. Models should not be relied upon as actual results will vary significantly. Index results do not reflect deduction of fees and expenses. Indexes are unmanaged therefore direct investment is not possible. Please read additional information in Important Disclosures.
In the next section we use forward-looking simulations to assess the potential range of funded status outcomes. The chart below compares two otherwise identical plans, one with a one-way and the other with a two-way glide path. The base case (50th percentile) funded ratio outcome is about 8% higher for the two-way glide path. This is not surprising as it has a larger allocation to higher return assets for more time. What is perhaps more surprising is that the downside, here depicted in the lighter red lines is also better for the two-way glide path. In other words, the higher volatility is actually associated with a long-term better outcome even in bad markets.
Source: BlackRock, as of Jan 2024. Based on ex-ante simulated outcomes. Charts show the range of outcomes over the ten-year period, with each quarter’s 25th, 50th, and 75th percentile funded ratio outcomes marked in colored lines. Please read additional information in Important Disclosures.
Finally, we also tested the asymmetrical two-way glide path in the same forward-looking analysis. We found that this glide path, as expected, performed somewhere in between the two: better long-term funded ratio outcomes than the one-way glide path, but worse than the simple two-way.
In real life, for our pension clients, it is not just the final outcome that matters, but also the journey. To assess how volatile the experience might be for different glide path designs, we looked at the maximum funded ratio drops for each glide path design using historical data, depicted in the chart below. Unsurprisingly we found that the drawdown was worse for the two-ways glide paths: 18% for the one-way glidepath versus 32% for the two-way glidepath. Of course, if these drawdowns were sustained over time, company contributions would be required, muting the extent of the reduction in funded ratios, Nevertheless, this is the exact scenario that most plan sponsors generally seek to avoid.
Maximum drawdown - 90% funded ratio (2006-2023)
Source: BlackRock, as of Jan 2024. Based on ex-post simulated outcomes. Hypothetical returns are not a guarantee of future results. Hypothetical results are for illustrative purposes only and do not constitute actual results. Results are based upon model assumptions and are subject to significant limitations. Models should not be relied upon as actual results will vary significantly. Index results do not reflect deduction of fees and expenses. Indexes are unmanaged therefore direct investment is not possible. Please read additional information in Important Disclosures.
In conclusion we find that plans with the risk tolerance to live through some market volatility may consider instituting a two-way glide path to take advantage of short-term market selloffs and raise the probability of reaching funded status goals.
Max 12-month rolling drawdown – 90% funded ratio (2006-2023)
Source: BlackRock, as of Jan 2024. Based on ex-post simulated outcomes. Please read additional information in Important Disclosures.
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.
