Developing an effective pension plan asset allocation strategy

Photo of a group talking through options in a consultation.

Selecting an asset allocation strategy for your defined benefit plan with the help of your investment adviser and actuary is a crucial step in developing your termination strategy. Your asset allocation will likely:

  • Impact the amount of contributions you’ll need to fund your defined benefit (DB) plan to termination
  • Control for the volatility of contributions from year to year
  • Help you maintain any improvements to the plan’s funded status

An effective asset allocation strategy begins with modeling your defined benefit plan assets against the liabilities

An asset liability modeling study can help identify asset allocation strategies that provide the highest probability of success.

An asset liability study simultaneously models your pension plan’s assets along with its liabilities. These forecasts help you evaluate the possible effect of various asset allocations on measures important to you and to your termination strategy. Those measures may include:

  • Probability of reaching your funding goal by a designated target date
  • "Value at risk" costs if negative scenarios occur
  • Funding ratio on a market value basis (accounting or termination measurement)
  • The amount of annual contributions or accounting expense

When completing an asset liability modeling study, several different allocations between equity and fixed income investments should be examined to assess the risks and outcomes associated with various investment strategies. The appropriate allocation for each pension plan is different because it’s based on your organization’s situation and risk tolerance.

Graphic listing what plan sponsors can expect from a stochastic forecast.

The 2 most common types of asset allocation strategies

With your forecasts in hand, it’s time to choose your asset allocation strategy. Most pension plans follow one of two approaches:

  • Static asset allocation, which has a fixed allocation among various asset classes. The portfolio is rebalanced to the fixed target allocation on a periodic basis.
  • Dynamic asset allocation. Here, the asset allocation adjusts on a regular basis according to a previously established rule, such as the funded status of the pension plan.

Graphic explaining the difference between two methods of forecasting a pension plan’s assets along with its liabilities.

Benefits of dynamic asset allocation

A dynamic asset allocation strategy will likely result in higher equity exposure when the funded status is low (for example, under 70%) and a reduction in equity exposure as the funded status improves. Reducing the equity exposure as the funded status improves can help:

  • Lock in gains as the plan’s funded status improves
  • Reduce downside risk
  • Prevent the DB plan from terminating with excess plan assets (which are subject to taxation)

If you decide that dynamic asset allocation is a good fit for your overall investment strategy, your actuary and investment adviser should coordinate their efforts closely, as changes in your plan’s funded status will generally trigger changes in asset allocation.

Sample glidepath for a hard-frozen defined benefit plan

With a dynamic asset allocation strategy, the pension plan allocates more assets to fixed investments as the plan's funded status improves. 

A chart showing how a plan’s asset allocation is adjusted on a regular basis to increase fixed assets as the funded status improves.

We can help

Understanding the potential risks and rewards of your asset allocation strategy is critical for fiduciaries of defined benefit plans.

Principal can provide asset liability modeling expertise to assist you and your advisor in building an asset allocation strategy that is right for your plan. Give us a call at 800-952-3343, ext. 22681 or contact your advisor to get started.

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.

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