Executive Summary: Top considerations for DB plan sponsors in 2025
When history looks back on 2024, it may be seen as a transitional year in DB plan management.
After interest rates and inflation spiked in 2022 and 2023, the economy seemed to be settling into a more stable environment and the Federal Reserve (“Fed”) began lowering interest rates. With the US presidential election behind us, offering some some clarity on future policy direction, there remains uncertainty around the timing and magnitude of some changes, which may lead to renewed volatility.
But what will this period mean for defined benefit (DB) plans moving forward? We anticipate a number of key areas where plan sponsors should be focused for the upcoming year as they look to manage their portfolios and liabilities. How can they prepare for potential interest rate movements? How should they think differently about return seeking assets? And for those who have benefitted from a dramatic improvement in funded status over the past few years and are fortunate enough to have a surplus, how can they use it and how will the pension risk transfer market evolve?
How will the economy impact defined benefit plans?
1. What does the current rate-cutting environment mean for long term pension discount rates?
Pension discount rates don’t follow the Federal Funds Rate in lock step. They are based on longer term yields and their movement tends to reflect expectations of future yield changes.
2. With credit spreads at historically low levels, how should sponsors be thinking about hedging credit spread risk and are measures of credit spread hedge ratios reliable?
Since pension liabilities are generally calculated using the yields on high-quality corporate bonds, the credit spread is an important but secondary concern (after Treasury yields) for sponsors trying to hedge interest rate risk.
3. How will unemployment and inflation affect interest rates?
Uncertainty about unemployment and inflation levels leads to uncertainty about interest rates. Sponsors concerned about hedging rate risk should be cautious about taking any positions that are biased to specific outcomes.
Portfolio construction and plan governance in the current environment
4. Is diversifying the liability hedging portfolio worthwhile?
Since liabilities are discounted using high quality corporate bonds, sponsors looking to hedge their portfolio should focus on using those bonds in their liability hedging portfolios. Other instruments are likely to introduce tracking error. The return seeking portfolio may be the best place to seek higher returns.
5. How should plan sponsors determine the opportunity set for the return seeking portfolio?
Illiquid alternatives can provide an advantage for perpetual portfolios with long time horizons. Sponsors with shorter time horizons may want to focus on more liquid public equities and below investment grade fixed income.
6. What is the state of the equity risk premium?
Given the rise in yields over the past few years, equity risk premiums have decreased, leading to a flatter efficient frontier and incentivizing sponsors to de-risk their plans.
7. Are plan sponsors with internal investment staffs looking to “lift-out” their investment operations to an OCIO model? Will more large sponsors look to outsource their plan management?
The trend to outsourcing investment responsibility has shifted to include more and more large sponsors with sponsors even transferring their internal staff to an OCIO provider.
I’m overfunded – now what?
8. In light of plans being overfunded, what potential uses are there for our surplus?
While previously sponsors shied away from building up “trapped surplus,” there are many ways to potentially derive economic value from that surplus. These strategies can include thawing frozen plans, directing to retiree medical benefits, or repurposing after a plan termination, among others.
9. Does Pension Risk Transfer (PRT) give up potential return?
Sponsors considering risk transfer should undertake a cost/benefit analysis comparing termination vs hibernation.
10. Is there a robust market for large plan terminations? How many insurers will participate? How will buy-in’s affect the potential structures of deals?
There are many insurers participating in plan termination annuity placements today, with the market volume growing steadily. Buy-In deals offer sponsors an opportunity to lock in pricing before commencing the 12-18 month process of termination.
11. How will recent lawsuits affect the fiduciary environment for PRT?
Fiduciary guidance in pension risk transfer annuitization has long been governed by ERISA and the Department of Labor Interpretive Bulletin 95-1. 2024 saw the start of a potential new trend of lawsuits – cases challenging the insurer selection process for certain annuity contracts. Sponsors should engage an independent expert to assist with a thorough due diligence review of all insurers under consideration of any transaction.
