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In 2017, we wrote about the importance of positioning a corporate defined benefit (DB) plan’s return-seeking portfolios for changing market conditions. We could not, of course, have foreseen the events of the ensuing years, from a global pandemic to a war in continental Europe, or the resulting macro and market shifts — from disinflation to inflation, from recession to growth to potential stagflation, from bull market highs to bear market lows. Changing conditions indeed.
With this backdrop, we felt it was an opportune time to reflect on our return-seeking approach, test its merits, reaffirm our confidence where earned, and update where appropriate. This takes on additional relevance given changes in funded status in recent years. Strong equity markets in 2021 and rising interest rates in 2022 have lifted many plans close to or beyond fully funded status, but with a wide distribution of results. As of 16 September 2022, the aggregate funded ratio for plans in the Russell 3000 Index was 101%, just shy of the 102% peak from earlier in the year, which was the highest level since the global financial crisis. However, the bottom 25th percentile was only 82% funded, while the top 25th percentile was 108% funded.1
In our view, return-seeking portfolio construction is an important consideration for plans at all stages of their glidepath — whether the focus is preserving funded status as portfolios approach their end state or seeking further funded-ratio improvement. In this paper, we will:
Our return-seeking portfolio construction philosophy remains unchanged from our 2017 white paper. We recognize the critical role core equities play in funded-ratio growth over time. However, equities also contribute to funded-ratio volatility and drawdowns, from which it can be challenging to recover.
In addition, plan sponsors face an asymmetric risk profile as they do not benefit from excess returns (trapped surplus) but are on the hook for any shortfalls in plan assets relative to plan liabilities. Declines in funded status can also trigger immediate consequences for balance sheets, cash flows, income statements, and PBGC premiums.
Viewed through this lens, balancing upside equity participation with funded-ratio drawdown mitigation is key to long-term success. How plan sponsors weigh these two objectives may vary depending on the stage of their glidepath journey. For plans with strong funded positions, mitigating funded-ratio drawdowns becomes even more critical to avoid losing hard-won funded-ratio improvements. Plans that are underfunded may place greater emphasis on maximizing returns but with an aim to mitigate erosion in funded status along the way. Our return-seeking portfolio construction philosophy recognizes these multiple objectives and sensitivities by incorporating the three building blocks shown in Figure 1: core equities, defensive strategies, and diversifiers.
Each of these building blocks plays a crucial role:
Core equities allow plans to take advantage of periods of potential funded-ratio growth, generally environments characterized by strong equity returns and rising discount rates.
Defensive strategies also seek to improve funded status, but with an eye toward downside mitigation when equities weaken.
Diversifiers typically have lower equity correlation and more unique return streams, and seek to cushion drawdowns in the most challenging equity environments.
We believe this building-block approach lends itself well to the challenges plan sponsors face at all stages of the glidepath. These challenges may be exacerbated by market conditions going forward, given the stark tradeoff faced by central banks seeking to control inflation while supporting growth. Because of this shifting dynamic, central banks may be transitioning from suppressing volatility (cutting rates whenever the economy weakens) to magnifying volatility (for example, raising rates to fight inflation even as growth slows). This could mean structurally higher equity and interest-rate volatility — and potentially more funded-ratio volatility as a result.
With this outlook in mind, we think plan sponsors should consider increasing or adding allocations to defensive and diversifying strategies. The rationale underpinning defensive strategies is…
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1Funded ratio and discount rate estimated as of 16 September 2022 by Wellington Management based on change in highquality corporate bond yields (Bloomberg US Long Credit Aa) since 31 December 2021 and performance of equities (MSCI World), bonds (blend of Bloomberg US Long Govt/ Credit and Bloomberg US Aggregate), other investments (blend of HFRI Fund Weighted Composite Index, MSCI All Country World, and Russell 2000), and real estate (NCREIF Property Index). Results are at the aggregate Russell 3000 Index level for companies with a December fiscal year end. Actual results may differ. | Sources: FactSet, Wellington Management.
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