In the defined benefit universe, words matter, according to a new paper released by Willis Towers Watson (WTW), and the wrong definitions can lead to unnecessary and excessive risk, as well as wasted time on short-term issues that have little or no bearing on the success of pension plans.
In its paper, WTW aims to update and evolve the business language lexicon for defined benefit pension plan sponsors. It says the new definitions can help improve how sponsors, consultants, and managers address pension plan challenges going into 2018. The paper outlines 10 defined benefit investment terms, and provides for each a traditional, and now outdated, definition, as well as a new definition WTW believes is more relevant today.
1. Fiduciary duty
Old Definition: Actions taken are documented and reasonable.
New Definition: Actions taken are subject to a higher level of scrutiny as more parties are considered fiduciaries, and are being held to higher standards that require expertise.
2. Full Funding
Old Definition: Having assets that are equal to, or exceed accounting liabilities.
New Definition: Having assets that are equal to, or exceed the organization’s desired funding target, which could reflect market cost required to settle obligations, signify the ability to run them off over the very long term, or support future benefits for employees.
3. Time Horizon
Old Definition: The very long period of time until the plan makes its last benefit payment.
New Definition: A series of time frames that vary in length depending on sponsor objectives, plan liability profile, and the desired approach to delivering retirement benefits over the long term. In some cases, the time horizon can be very short.
4. Investment Strategy
Old Definition: The plan’s static asset allocation and investment manager lineup.
New Definition: The dynamic process of achieving a series of risk allocations that vary with market conditions, and reflect the plan’s progress toward its funding and settlement objectives.
5. Interest Rate Risk
Old Definition: A financial risk that can result in significant gains or losses relative to the liability if rate changes occur within the time horizon. Plans with interest rate risk often maintain a large and risky “short position” relative to the liability, potentially larger than other risks in their portfolio.
New Definition: A liability valuation factor where increases are already priced into the forward curve, which means potential gains the risk are lower than expected. WTW says it is often the most significant risk for pension plans, extremely difficult to time, and vital for portfolio construction.
6. Liability-Driven Investing (LDI)
Old Definition: Extending interest rate exposure of plan assets, primarily through long duration, fixed-income investments.
New Definition: Making any investment decision that takes the profile of the liability into account. This can extend beyond long-duration, fixed-income assets, as long as the decision was made to manage risk in an asset and liability context.
Old Definition: Allocate across various regions, such as US, non-US, emerging markets, and investment styles, such as value or growth within a portfolio.
New Definition: Use a greater variety of return drivers to help enhance return and/or potentially reduce total portfolio risk. Look beyond traditional beta, alpha and interest rate exposures into the potential risk premia from illiquidity, complexity or difficult implementation. Avoid constraining new investment ideas with traditional asset-class buckets.
Old Definition: Execution of investment ideas by a part-time fiduciary committee that meets infrequently.
New Definition: Proactive, timely, and transparent portfolio management and execution within cost and risk budgets. This is supported by a deep internal or outsourced resource structure that empowers committees to focus on their strategic goals for the pension.
Old Definition: Outsourcing just your manager selection activity to a third party or outsourcing more, including strategy setting.
New Definition: Enhancing your ability to make strategic decisions and achieve strategic goals by outsourcing their execution to third parties. Delegation aims to improve efficiency of implementation, reduce costs, manage risks within the context of a defined investment strategy, and reallocate resources toward the core business.
Old Definition: Achieving the desired return, whether this is in the form of manager outperformance of its benchmark, meeting a forward-looking target or hurdle rate, or beating peers.
New Definition: The ability to execute the firm’s objectives, including those related to funded status and risk management, and to ultimately secure benefits for all plan participants. Oversight and monitoring of the strategy focuses on progress relative to objectives, with less emphasis on short-term investment return goals.