Seeing an Oasis of Opportunity How COVID-19, Inflation, and ESG Can Deliver Value to Defined Benefit Plans

The current discussion around inflation and its impact on long-term interest rates continues. Inflation-sensitive exposures such as broad-based real assets (public and private markets) and inflation-linked bonds should be elemental to a plan’s inflation risk mitigation strategy. If the market faces a sustained inflationary regime, resulting in higher nominal yields and discount rates that reduce the value of plan liabilities, the risk of stagflation may have an offsetting (or more) negative impact on return-seeking risk assets.

Unfortunately, the underfunded plans most vulnerable to inflation are also less likely to reduce liabilities through pension risk transfer (PRT), given the internal cost of annuitization — both in time and money. Here, the two areas of greatest concern become linked by the sponsor’s inability to de-risk, affecting both short- and long-term goals and establishing a strong argument for outsourced support.

When ranked, resourcing was the leading response for both DB (48% ranked 1st) and DC (46% ranked 1st) delegation drivers, with ESG as the unexpected second-ranked reason by DB (40% ranked 2nd) and DC (38% ranked 2nd) sponsors. The pursuit of efficiency, both in operations and managers’ fees, was a third-place consideration.

However, the greatest data disparity — a 10-point difference between DB and DC responses — was found with risk management. For DB, 76% didn’t rank this item as an inspiration to outsource, but for DC, 34% of respondents ranked it as a rationale (66% did not), suggesting litigation concerns drive risk management fears and could be a trigger for DC OCIO.

This idea was echoed by Glidden, who said, “Our DC decisions are driven more by litigation risk. We are much more focused on fees and have given ourselves fewer degrees of freedom.”

The idea of risk may also address why ESG stands out as the unexpected driver of delegation. Sooner or later, the investment committee will need to answer the question, “What’s the plan’s ESG position?” Engaging an outside firm to help define the role of ESG in DB and DC asset pools frees up in-house resources, offers a broader market perspective — from monitoring ping-ponging public policy to assessing existing portfolios to vetting future fund selection — and offloads a portion of the fiduciary liability. Such expertise allows the committee to recommit to both near- and long-term goals while gaining the benefits of doing well by doing good.

A final note about performance: When sponsors were asked about the greatest opportunity for DB improvement, the leading response (55% ranked first) was investment performance. This same dimension was also cited by the majority (44%) as the highest risk to achieving long-term goals on a desired time frame. That said, investment performance holds a far lower ranking for both DB and DC sponsors in terms of motivating outsourcing.

Glidden offered a perspective: “I think about what is the highest and best use of all my staff. We do a lot of reporting, filing, regulatory stuff. That’s not how we should be spending our time.” Here, it seems that investment performance isn’t the risk, but the team’s distraction from it.

COVID-19 has reframed corporate finance priorities today. Looking ahead, capital expenditure and investment committee talent redeployment in a post-DB era will offer new opportunities to corporations while reframing the retirement experience. With more precise tools available through advanced technologies, corporate finance decisions will have a greater impact on the bottom line, allowing in-house expertise to be allocated to evolving areas of retirement.

While inflation and PRT strategies are currently in demand in response to current market factors and pension commitments, the expected shift in the 2030 landscape suggests a move away from corporate DB and toward a DC/DB hybrid model that marries the autonomy of participant-driven saving with the security of a guaranteed income in retirement. In this new construct, inflation is hedged for each participant by age-appropriate investments (assuming a target date fund default), and while PRT actions help to clean out aging liabilities, annuitization expertise can be redeployed to lifetime income streams.

From a financial outcome and fiduciary accountability standpoint, ESG will become unignorable. To manage associated risk and returns, corporations must begin with a portfolio assessment and investment policy pledge, informed by internal or external expertise. State Street posits that the next decade will bring public policy advances, participant demand, and corporate commitments that will make ESG less of an add-on and more of an integrated investment lens — corporations can’t afford to have a blind spot.

Overall, survey responses suggested that the road to de-risking is neither straight nor smooth. Whether steered in- or out-of-house, the maneuverability of DB and DC strategies in response to corporate and market undulations determines whether plan goals are stalled or spurred by changes along the path. To stay the course, expertise is essential.