Seeing an Oasis of Opportunity
How COVID-19, Inflation, and ESG Can Deliver Value to Defined Benefit Plans
The defined benefit (DB) landscape is changing, driven largely by three notable factors: COVID-19, inflation, and ESG. While the future of DB will not look like its past, change is not always a bad thing. In fact, if thoughtfully navigated, market and regulatory advances can alter the route of today’s corporate DB plans and tomorrow’s retirement landscape for good.
Setting the Stage
State Street Global Advisors sponsored a survey of 100 US corporate DB plan sponsors in order to understand their current attitudes and future outlooks, with a focus on the exit. Our survey was fielded in July 2021 by Longitude of the Financial Times Group.
When looking ahead, respondents divided themselves into three categories: those seeking an exit, those looking to achieve self-sufficiency,1 and those intending to keep their plan open indefinitely. However, it appears that these paths are not as discrete as survey respondents report.
Figure 1: Reported Long-Term Pension Strategies
seeking an exit
looking to achieve self-sufficiency
Intending to keep the plan open
Source: State Street Global Advisors. Defined Benefit Outlook Survey of 100 US corporate plan sponsors in July 2021.
For example, those seeking an exit, primarily because the pension is viewed as a legacy asset that adds little value (63% of the 62 exit-oriented respondents), are also likely to pursue partial buyout risk transfers (45%) along the way and explore some form of delegation to an asset manager (27%). In addition, those 33 sponsors seeking self-sufficiency are also hedging their bets, with 52% saying they somewhat to strongly agree that while they work toward a long-term runoff, there is still a possibility they may change course and opt for an exit — though the costs are too high to make this a viable option today. Interestingly, the same percentage of self-sufficiency seekers somewhat to strongly agreed that their pension is a differentiating corporate asset, suggesting that the pension itself is not obsolete yet.
Not surprisingly, corporate plan funding status and plan size have an anecdotal impact on sponsors’ anticipated paths.
Those respondents seeking to keep their pensions open, though in the minority, shared the characteristics of being both well-funded, defined here as 80% to over 100% funded, and having the largest asset pools, most likely because size and funding strength afford these sponsors more options.
However, looking beyond the traditional vectors that segment the DB marketplace and their exit strategies, we explore the disruptions that began in the first quarter of 2020 and have drastically altered the marketplace: the COVID-19 crisis, inflation, and an unexpected ESG appetite. All sponsors are having to pivot, but the ones who will do so most gracefully are the ones who can see beyond the challenges to embrace the opportunities presented by these new elements.
Delaying Exit Strategies in Favor of Corporate Finance Pivots
When asked if the turbulence caused by the COVID-19 crisis impacted respondents’ time frame for achieving long-term pension plan goals, 44% said that their timeline had been delayed. Here, we posit that market upheaval was a significant factor, but an incomplete answer. Higher-priority organizational demands and redeployment of capital expenditure are likely additional drivers of DB delays.
“We lost a meaningful portion of our workforce last year between the early retirement and severance programs that we ran. Capacity dropped by 80%. But it’s given us a chance to take a new look at our route network, simplify our fleet, kick-start fuel efficiency initiatives, and refresh some of our gates. Here, pension management becomes part of our corporate strategy. There was an opportunity to issue debt and make some big portfolio trades that brought our pension up to 91% funded, which allowed us to take risk out of the plan.”
— Jonathan Glidden, Managing Director, Pensions at Delta Air Lines
Building on this assessment, Jonathan Glidden, Managing Director, Pensions at Delta Air Lines, said the business impacts of the pandemic forced a fresh focus on operational and capital redeployment while also enabling pension de-risking.
Noted Daniel Farley, Executive Vice President at State Street Global Advisors and CIO of the Investment Solutions Group echoes this connection, saying, “Liability-driven management isn’t simply an investment strategy, it’s a corporate finance strategy. ‘How much variability do I want to have in my contributions, in the net assets on my balance sheet, and what is the potential cost to reduce this variability?’ Sponsors manage pensions in the context of their overall business.”
Despite Delta’s $20 billion DB plan size, it has had its fair share of funding woes over the past two decades, beginning with the 9/11 terrorist attacks of 2001 and extending through the Great Recession of 2008. By 2012, it was, by Glidden’s description, “the worst funded plan in America by a lot” at 38% funded.
Delta’s decade-long balance of contributions, conscientious pension portfolio management, and strategic operational investment has offered a template for turnaround, suggesting that a pandemic-driven delay isn’t necessarily cause for concern, but an opportunity for reassessment and an improved long game.
Managing Inflation to Align with Short- and Long-Term Goals
When it comes to inflation risk management, 56% of well-funded plans (representing 84% of the total sample) say that dimension of plan oversight is aligned with long-term goals. However, plans less than 80% funded (representing 16% of the total sample) have a different view. Here, only 31% are in agreement, likely because of these sponsors’ reliance on growth assets, which makes their plans most susceptible to loss in inflationary environments. Figure 3 represents survey responses in aggregate, without the funded status filter.
Figure 3: Assessment of Current Practices’ Alignment With Long-Term Goals
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.
Tackling New Territory with OCIO
While our survey focused on DB plans, 62% of respondents also have defined contribution (DC) oversight. Therefore, we explored investment outsourcing (referred to here as OCIO2) drivers for both DB and DC plans, identifying areas of consistency and disparity.
Figure 4: A DB vs. DC Comparison of Delegation Likelihood and Levers
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.
A New DB Era
Ushering in a New Decade of Change
By 2030, all baby boomers will be at least 65 years old and most will have retired. This is the same year the greatest concentration of survey respondents, over a third, plan to have exited or wound down their DB plans.
Figure 5: Time Frame Expectations for Achieving Long-Term Goal
The year and decade of 2030 will see a change not only to the generational makeup of the workforce, but also to retirement plan structures and internal investment teams. We offer three predictions for the retirement plan landscape in 2030:
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.
About the Survey and Sample
State Street Global Advisors conducted a survey of 100 US corporate defined benefit plan sponsors in July 2021. Decision-makers spanned 15 industries, the top four representing 45% of the sample (16% financial services, 13% health care, 9% retail, and 7% oil and gas). The top three job titles made up 74% of the represented roles (43% VP of finance, 19% VP of HR, and 12% CFO). The objectives of the survey were to understand DB sponsors’ current attitudes and future outlooks surrounding the plan and to identify potential trends — per plan characteristics and objectives — that could make a DB plan more or less receptive to delegation.
1 “Self-sufficiency” is defined as reaching a position where the sponsor can continue to run the plan until its last participant has died, without requiring further corporate contributions.
2 “OCIO” or outsourced chief investment officer is defined as the practice of delegating a significant portion of the investment office function to a third-party provider, typically an investment management or consulting firm.
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