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Top defined benefit considerations in 2022
Top defined benefit considerations in 2022 2
The world is in the midst of a revamp Mercer’s consultants are
ready to guide you through
on various fronts. Monetary policy and each of these issues:
thinking are being reshaped as inflation Is inflation an issue for
balloons beyond central bank targets DB plans?
and policymakers grapple with the Should sponsors be reviewing
consequences of bloated balance sheets, their interest rate hedge ratios
to take advantage of low
inflated asset markets and disintegrating rates?
global supply chains. In parallel,
How should sponsors hedge
regulators are increasingly active, with the their plan termination liability?
unexpected announcement of a global
What fiduciary challenges do
minimum corporation tax and China sponsors of both DB and DC
imposing outright bans on cryptocurrency plans face?
transactions and for-profit education. How should sponsors reflect
environmental, social and
We encourage defined benefit (DB) plan governance issues in their
policies?
sponsors to note the lessons learned and
plan accordingly for the impact of the new Should dynamic asset
allocation play a role in
environment on their financial realities. strategy?
The considerations outlined in this How can corporations manage
paper address a range of topics, from risk on a global basis?
the effects of the COVID-19 pandemic How can plans benefit from
to opportunities for diversification, capital efficient strategies?
rebalancing and risk-transfer strategies What liability should be the
to the routine exercise of setting financial basis of a plan’s glide path?
assumptions. How would an open-plan
strategy differ from that of a
frozen plan?
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Top defined benefit considerations in 2022 3
1. Is inflation an issue
for DB plans?
During 2021, inflation came in above already-elevated On the asset side, higher inflation would likely lead to
expectations, driven by myriad factors, including supply- higher interest rates. However, because most underfunded
chain pressure and a tightening labor market. These DB plans are not fully hedged, the liabilities would see
conditions have persisted, and we believe they will continue a greater decrease than the fixed income assets. Over
to pose a risk in the future. However, we don’t view this an extended period, higher inflation can lead to higher
increase in inflation as a significant risk for DB plans since equity values, although sector-by-sector impact may vary.
higher inflation is likely to be more significant in lowering Higher real interest rates, which may be necessary to
liabilities than in lowering asset values. fight inflation, potentially result in lower equity valuations.
Active management of equity assets can help navigate the
For most US corporate DB plans, inactive participants have landscape, and real assets, such as infrastructure and real
fixed-dollar liabilities. The pension promises of the past estate, may also help mitigate inflationary surprises.
20 years have proved to be more expensive than employers
anticipated — in part, because interest rates and inflation Plan sponsors should continue to review their interest
were lower than expected. Higher inflation would lessen the rate hedge ratios and their growth portfolios (for example,
increase in the cost of past benefits but would likely affect equities and real assets) in light of the recent increase
employee wages, which would increase the cost of future in inflation.
benefit accruals for plans that are not frozen.
© 2021 Mercer LLC. All rights reserved.
Top defined benefit considerations in 2022 4
2. Should sponsors be reviewing their
interest rate hedge ratios to take
advantage of low rates?
DB plans face two major investment risks: interest rate investors have traditionally expected interest rates and
movements, which drive changes in the “goal post” (the stocks to move in opposite directions (bond and stock prices
liability value), and return-seeking asset risk, which is the move in the same direction) as opposed to the pattern
source of returns to move toward and exceed that liability over the past few decades of a mostly positive correlation
goal. In general, taking interest rate risk is unrewarded if between rates and stocks. If inflation rises and the Fed
rates just cycle around a central level but can be rewarded pushes up rates to counteract it, from a funded status
(or penalized) if rates move up (or down) toward a new level perspective, a lower hedge ratio may help offset some of the
and stay there. potential fall in equity valuations.
Over the past decade, US interest rates have been very Although this outlook presents an opportunity for plan
low due to a combination of low inflation and central bank sponsors, a decline in rates could have the opposite effect.
intervention through quantitative easing (buying bonds).
Higher inflation, particularly coupled with a reduction in Plans considering such an approach will need to
monetary stimulus, would likely raise the long-term interest answer a few questions before taking action:
rate levels.
• Is there sufficient upside for the plan (either closing
Given the pandemic supply shortages, employment a funding deficit or offsetting cash requirements
disruptions and the magnitude of past stimulus, there is a for future accruals)?
reasonable case for inflation and interest rates being more
likely to rise than to fall from the levels of under 1.75% on • Is the plan’s time horizon long enough to make up
the 10-year Treasury in October 2021. the ground if rates fall?
If rates increase, a lower interest rate hedge ratio would • Is the expected pace of rate increases fast enough to
then decrease liabilities more than assets, improving funded offset any yield give-up, such as from term premium
position, which might have the added benefit of hedging or credit spreads?
against poor outcomes from return-seeking assets (such
as equities). In moderate and rising inflation environments, • Does the rate exposure fit within the overall risk
tolerance and risk budget?
© 2021 Mercer LLC. All rights reserved.
Top defined benefit considerations in 2022 5
3. How should sponsors hedge
their plan termination liability?
As part of the plan termination process, obligations all terminal lump sum payments will be made). Once those
can be satisfied in one of two ways — by paying a lump rates have been determined, the expected lump sum
sum directly to plan participants or by purchasing an amount is locked in and no longer subject to any interest
annuity contract from an insurance company. The sum of rate risk, meaning the most effective hedge is cash. The
these two components represents the plan termination costs associated with the portion of the obligation to be
liability (PTL). The PTL is typically in excess of the plan’s settled through an annuity contract usually remain subject
accounting liabilities (usually between 100% and 110% of to interest rate volatility up to the point of actual purchase
the accounting liability) but can vary depending on several and are best hedged through a liability-matching mandate
factors, such as: of high-quality bonds.
• How aggressive or conservative the sponsor is in For plans that define the benefit in terms of an account
selecting the discount rate, mortality and other balance (for example, cash balance plans), the lump sum is
demographic assumptions for accounting purposes usually not subject to any interest rate risk. Once a decision
has been made to terminate, investing the expected
• The relative weights of retirees and nonretirees account balance payments in cash or very-short-duration
in the plan fixed income will likely be the most effective hedge.
• The take-up rate of participants electing a lump Although hedging strategies tend to be well defined, a
sum during the termination window critical element that remains unknown is the portion of
the obligation that will be settled by participants electing
• The cost to purchase annuities, which varies by lump sums rather than purchasing annuities. With this in
participant status and plan provisions mind, one approach to setting the hedging strategy is to
evaluate different lump-sum election rates and the impact
Many plan sponsors, especially those that already have of the alternative hedging strategies under various market
sufficient assets, want to minimize the difference between conditions (that is, increasing/decreasing interest rates
the PTL and the assets. This requires effective hedging of and/or credit spreads). This information can provide insight
the lump sum and annuity purchase cost. into how the assets and plan termination cost may react
differently and what risk the plan sponsor is willing to take.
For traditional pension plans that define the benefit as an
annuity, the lump sum to be paid is typically calculated Sponsors contemplating plan termination should conduct
as the present value of the annuity stream using market PTL analysis to determine the rate sensitivity of the terminal
interest rates. However, it is common for these rates to be liability and an asset allocation strategy to minimize
locked in well in advance of the expected payment date volatility of the termination outcome.
(for example, up to four months before the year in which
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Top defined benefit considerations in 2022 6
4. What fiduciary challenges do sponsors
of both DB and DC plans face?
Committees with fiduciary responsibility over both a Manager selection
DB plan and defined contribution (DC) plan are often
There may be some fiduciary risk associated with making
concerned about the need for consistency in the investment
different decisions regarding the same investment product
decisions for each. This is particularly true in an increasingly
in DB and DC plans overseen by a committee. Most notably,
litigious environment. Two areas receiving growing
terminating a manager due to concerns over expected
attention are the decisions regarding active versus passive
future performance in one plan while taking no action in the
investment management and the hiring and firing of
other plan could raise questions regarding the prudence
investment managers.
of such decisions. Less concerning are decisions to hire
different managers for similar roles in DB and DC plans. For
Active versus passive management
example, risk appetite as it pertains to volatility or tracking
Plan sponsors should consider including a tier of passively error may be greater for a DB plan, where a committee can
managed investments and a tier of actively managed ensure adequate diversification of the manager structure.
investments for the major asset classes in a DC plan, There may be advantages to hiring the same managers in
balancing the needs of those seeking lower costs with those the DB and DC plans. Fee savings could be available, and
looking for outperformance. Such an approach may differ there may be a reduction in the monitoring burden. That
for the DB plan, which might favor passive management said, fiduciaries need to consider the best interests of each
in relatively efficient asset classes and active management plan’s participants independently.
in less efficient ones. We believe different alignment of the
approaches for the DB and DC plans can be prudent for a We encourage plan sponsors to make the decisions
fiduciary committee. described here with one eye on the investment
considerations and the other on the potential legal
ramifications. Fiduciaries should take care to thoroughly
document their reasoning. It’s important to seek input not
only from investment advisors but also from legal counsel.
© 2021 Mercer LLC. All rights reserved.Top defined benefit considerations in 2022 7
5. How should sponsors reflect
environmental, social and governance
issues in their policies?
Environmental, social and governance (ESG) factors are For DB plan sponsors, previous Department of Labor
an increasingly important and valid consideration for (DOL) guidance has presented a significant hurdle to
DB plan sponsors and investors. They have moved well considering any factors that lacked a well-defined and
beyond values-based considerations into critical investment explicit impact on expected returns. While the spirit of the
considerations. guidance has always been to protect beneficiaries, the strict
language prevented investors from incorporating many
Environmental considerations (that is, issues of considerations that may have lacked specificity but that
sustainability) are impacting more businesses. The risks of could reasonably be considered significant with regard to
continuing changes to the climate, and the steps taken by long-term results. As of autumn 2021, the DOL has released
governments, businesses and individuals to mitigate these draft guidelines that provide more flexibility to include
effects, have impacted investments and will continue to such considerations in investment decisions. This would be
do so. Such factors present both risks and opportunities. an important adjustment for investors, allowing them to
Investors should consider the impact on long-term return incorporate the consideration of events and outcomes that
expectations and risk management as well as within may have an uncertain probability but a significant impact.
investment portfolios.
How might a pension plan sponsor adopt ESG considerations
Social issues, particularly diversity, equity and inclusion, in its DB plan investment decision-making process?
are core principles for many businesses and investors.
The impact diversity can have on investments — and the Here are a few possibilities:
impact investors can have on society through their own
1. Consider the quality of the ESG investment process
actions — are both tangible and significant. Mercer’s
adopted by potential managers in selection decisions
research indicates that diversity of thought, often linked to
and/or the ESG characteristics of current funds.
academic, professional and social background, is beneficial
to investment teams, allowing greater perspective, broader
2. Monitor managers for the implementation of their ESG
viewpoints and potentially more effective risk management.
investment processes and/or the ESG characteristics of
Seeking diversity may improve investment outcomes and
their portfolios.
promote core issues for many investors.
3. Monitor investment managers’ voting and
Governance, in its many forms, has always been a critical
engagement activity, particularly on controversial
factor in the success of organizations and societies. Both
ESG issues.
positive and negative impacts of governance can be seen
every day. We believe businesses that fail to establish
4. Seek investment managers who incorporate
well-defined stakeholder objectives and align their actions
diversity within their organizations.
to achieve those objectives put long-term success at risk.
Consider the challenges in China resulting from the impact
of both government and corporate actions. Long-term
investors should encourage governance approaches that
facilitate a healthy, sustainable business and align with their
long-term investment horizons.
© 2021 Mercer LLC. All rights reserved.Top defined benefit considerations in 2022 8
6. Should dynamic asset allocation
play a role in strategy?
An effective dynamic asset allocation strategy provides an Dynamic positions, in our view, should be based on a one-
opportunity for incremental return generation, which has to three-year outlook, with a focus on taking advantage of
become increasingly essential to achieving targeted returns market dislocations, as opposed to tactical positions that
on assets. Within a DB plan, we recommend that dynamic attempt to time markets. Taking outsized short-term bets
asset allocation strategies be managed with a defined risk runs contrary to a long-term strategic approach that fits
budget so that risk from dynamic positioning does not the plan sponsor’s risk tolerance and objectives. And, if the
overwhelm strategic goals. This requires that investment outsized positioning proves wrong, it can detract significant
policy guidelines allow for asset allocation flexibility — but value. However, accumulating incremental returns from
with clear guardrails and well-defined benchmarks. These modest dynamic tilts to well-understood opportunities
will ensure that the relative risk contribution of dynamic within a risk budget can help plan sponsors more effectively
positions can be understood on a forward-looking meet objectives over time without taking too much risk or
basis in combination with the ex-post performance straying from strategic goals.
attribution analysis.
© 2021 Mercer LLC. All rights reserved.Top defined benefit considerations in 2022 9
7. How can corporations manage
risk on a global basis?
Global organizations with pension plans in several countries funding policy. The goal for headquarters should thus be
typically want to ensure that those with local oversight to provide this broad direction without exerting so much
of such programs implement an effective governance influence that it takes on fiduciary responsibility as well.
framework.
One way to assist headquarters in fulfilling this role is
Some of the characteristics of that framework include: by creating a global risk profile for all the DB plans of an
organization, allowing headquarters to understand the risk/
• Compliance — Ensure compliance with external and
reward tradeoff of different management options in various
regulatory requirements and internal guidelines.
countries. Oversight of global risk levels by geography
can be accomplished using tools such as Mercer’s DB
• Performance — Optimize operational efficiency and
Dashboard, which allows parent organizations to view
maximize return on investment within appropriate
consolidated risk across all countries of operation and drill
risk tolerances.
down to gain a better understanding of the decisions being
made at local levels. With such a tool, sponsors can model
• Change — Manage change efficiently and effectively.
the impact on total organizational financial positions due
In our experience, those with local oversight also appreciate to sensitivity factors (such as equity performance, interest
some broad direction from headquarters related to key rates, inflation and mortality) and direct changes in those
plan management policies, including asset allocation and geographies that will have the greatest impact.
Figure 1. Mercer’s DB Dashboard
Source: Mercer, for illustrative purposes only
© 2021 Mercer LLC. All rights reserved.Top defined benefit considerations in 2022 10
8. How can plans benefit from capital
efficient strategies?
The low expected return environment presents challenges Enhancing returns: Portable alpha strategies can
to corporate plan sponsors, particularly underfunded be implemented within the fixed income portfolio to
plans that need returns to help close the funding gap. enhance returns with long-duration credit exposure
For well-funded plans, making sure the returns from the obtained in a capital-efficient manner, allowing capital
liability hedging portfolio keep pace with liability growth is to be freed up and invested in market-neutral absolute
increasingly important. Our opinion is that capital-efficient return strategies.
solutions can help address both these issues and create
significant value to plan sponsors. When we say “capital- • Return-seeking portfolio
efficient,” we mean strategies that allow a plan sponsor to
Typically, earning higher returns requires incurring
obtain notional exposure to an investment greater than the
greater risk/volatility. Although core market exposures
capital funded.
(beta) can be accessed at potentially very low fees,
these come with a high opportunity cost, as they take
We’ve broken down capital-efficient applications into three
up capital in the sponsor’s portfolio. Capital-efficient
buckets: liability-hedging, return-seeking and other.
solutions allow sponsors to replace these core beta
exposures and free up capital to invest in excess return
• Liability-hedging portfolio sources. For instance, S&P 500 Index exposure can easily
Increasing duration: Plans in the early stages of the be replaced with a futures position or a total-return
liability-hedging journey often have minimal capital swap that requires an allocation of 25%-50% of capital.
allocated to fixed income instruments — and, often, The costs of the beta replication may be slightly higher,
there is not enough duration to bring the aggregate but the ability to generate higher returns is what gives
portfolio duration up to its desired target. Capital- the strategy real value.
efficient solutions like Treasury futures or interest rate
swaps can be used to increase the duration without • Other applications
requiring an increase in the allocation into fixed income Other capital-efficient solutions include cash
instruments, allowing plan sponsors to retain (or even equitization, rebalancing, de-risking along a glide path
increase) their allocations to return-seeking investments and transition management.
to generate returns.
Capital-efficient solutions represent powerful tools
Fine-tuning the liability hedge: Plan sponsors looking a sponsor can use to improve overall risk/return
to fine-tune the liability hedge can use capital-efficient characteristics and enhance portfolio operations and
strategies to plug gaps in key-rate-duration mismatches implementation. These techniques are particularly valuable
to allow for better alignment of assets and liabilities in a low-return environment, where every incremental basis
across the yield curve. point is important.
© 2021 Mercer LLC. All rights reserved.Top defined benefit considerations in 2022 11
9. What liability should be the
basis of a plan’s glide path?
A glide path is intended to decrease funded status volatility In the case of a frozen plan sponsor that might be targeting
as the plan moves toward “full funding.” A successful a plan-termination exit strategy, full funding might be
execution of this strategy means that upon reaching full defined as the plan-termination cost. Although this
funding, the plan can be managed with no or minimal measure is more difficult to estimate, it may serve as a good
financial funding from the plan sponsor. definition of the liability for the glide path.
A key consideration in designing a glide path is identifying For plans that have ongoing accruals, additional thought
what full funding means, as it is unique to each plan needs to be given to what full funding means. Some
sponsor’s situation and objectives. sponsors are willing to endure higher levels of funded
status volatility to help close any shortfall relative to
For those with frozen plans that are looking to maintain benefits already accrued and are willing to contribute cash
the plans indefinitely, the objective might be to have in the future to pay for future accruals. The glide path
sufficient assets to pay out all future benefits and expenses. liability measure for this strategy would typically be the
In that case, using a liability measure based on market ABO. Other sponsors are willing to continue to take risk
discount rates and benefits already accrued is a reasonable until all past and future service benefits are fully funded.
approach. The accumulated benefit obligation (ABO) used The glide path measure to use in this situation needs to be
for financial reporting would be suitable, as it reflects this more encompassing to include these future accruals. The
definition of the liability. present value of benefits (PVB) is a measure that reflects
these dynamics.
Plan type Suggested glide path liability measure
Frozen, with a view to maintaining the plan ABO — reflects all benefits earned to date
Frozen, with a view to terminating the plan Plan-termination liability
Ongoing accruals ABO if sponsor is willing to fund new accruals
PVB if sponsor wants to fund ongoing accruals through
capital markets
Plan sponsors should understand different liability
measures and what they mean. After gaining a thorough
understanding of the measures, the sponsor can choose
which one reflects its objectives and execute a de-risking
strategy and glide path in an aligned fashion.
© 2021 Mercer LLC. All rights reserved.Top defined benefit considerations in 2022 12
10. How would an open-plan strategy
differ from that of a frozen plan?
Open or recently closed plans with significant ongoing outside public equity investments for those with longer
accruals face a particularly challenging environment. In the investment time horizons. Private investments, both equity
current environment, the prospects for strong investment and debt, require a longer investment horizon, as they call
returns to be the largest contributor to improving funded for a commitment to stay with investments for five to 10
status and offsetting future costs are not particularly good. years. However, the tradeoff is that investors can access
Having a current strategy review is critical to understanding more attractive investments and earn better returns.
the tradeoff between reaching for investment returns and
accepting lower risk and lower-return investments and We encourage open plans to consider a broad range of
planning for a reasonable contribution strategy. diversification options and evaluate the impact of market
volatility on potential contribution requirements.
A strategy review can also provide insight into the impact of
opportunities for improving investment results by moving
© 2021 Mercer LLC. All rights reserved.Top defined benefit considerations in 2022 13
Contact us
We welcome feedback and dialog with you and your
organization as you plan for the upcoming year.
Please reach out to your consultant or to any of our
colleagues below.
Neeraj Baxi
+1 212 345 9258
neeraj.baxi@mercer.com
Carlin Calcaterra
+1 720 297 6020
carlin.calcaterra@mercer.com
Chris Ebersole
+1 215 982 4371
chris.ebersole@mercer.com
Scott Jarboe
+1 202 331 2523
scott.jarboe@mercer.com
Jay Love
+1 404 442 3268
jay.love@mercer.com
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December 2021
vary and actual results may differ materially.
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