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Executing a dynamic asset allocation strategy

In order to successfully terminate your defined benefit (DB) plan, you’ll need an effective asset allocation strategy. The strategy should:

  • Help manage volatility
  • Lock in improvements in funded status
  • Minimize liabilities

Fortunately, a dynamic asset allocation strategy may be an effective way to do all 3.

What is dynamic asset allocation?
It’s an investment strategy where a defined benefit plan’s asset allocation is adjusted on a regular basis according to a previously established rule, such as the plan’s funded status.

The goal of a dynamic asset allocation strategy is to link the volatility risk of your plan’s portfolio to its funded status, gradually reducing risk as the plan approaches termination.

How to put a dynamic asset allocation strategy to work for you

Request a customized glide path

To make the most efficient use of your defined benefit funds, your actuary should assist in developing a customized glide path strategy. This strategy looks at a plan’s asset allocation relative to its termination liabilities, adjusting that allocation based on changes to your plan’s funded status (also known as termination funding ratio).

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.

As the funded status of your plan improves or as interest rates increase, the glide path generally shifts plan funds from equities into longer duration fixed income investments that are more in line with the plan’s liabilities. The glide path strategy should be included in the investment policy statement for current and successor plan fiduciaries to reference.

Review your termination funding ratio at least quarterly

Understanding where your pension plan currently resides on the glide path—using the termination funding ratio—is the 1st step toward reallocating investments.

What is termination funding ratio?
It’s a ratio of the percentage of plan assets to plan liabilities, calculated following the funding rules specific to terminating plans.

A dynamic asset allocation strategy is built to gradually reduce financial risk and help lock in funding status gains as they occur. To capture these de-risking opportunities effectively, termination funding ratios should be calculated at least quarterly. This disciplined process of reducing financial risk as plan assets and liabilities come into balance can help minimize the chance that unfavorable economic variables will increase the time or contributions needed to terminate.

Termination funding ratios must also be based on the appropriate liability. For hard-frozen plans, this means using a termination liability, which is higher than the funding target required for ongoing/active defined benefit plans.

Make sure your team is working together

There can be a lot of players involved in executing a dynamic asset allocation strategy, including an actuary, financial professional, plan service provider and investment manager. Coordination among this team is key. If your team of DB professionals is out of sync, you could be missing critical opportunities to reduce risk and lock in funded status gains.

Consider a customized bond portfolio

If you have a large defined benefit plan (more than $50 million in fixed income assets), your organization may benefit from having the fixed income portion of your assets actively managed in a customized bond portfolio. Doing so helps provide more precise liability matching than a non-customized portfolio of bonds and assists the bond portfolio manager in generating targeted returns through intended risk-taking within the fixed income portion of the plan.

Monitor your progress toward plan termination

Throughout the execution of your dynamic asset allocation strategy, you should monitor your goals and progress toward terminating your pension plan and evaluate additional risk management opportunities beyond dynamic asset allocation. For example, perhaps you could reduce some of the risk—and cost—of your plan by transferring the risk to other parties: either to plan participants electing lump sum payments or to an insurance company through an annuity purchase.

Maintaining your funded status

When defined benefit plan assets become sufficient to cover a plan termination, it’s important that the portfolio be invested in a manner that helps maintain the plan’s fully funded status. The plan termination process (including government filings, etc.) can take 12 to 18 months between notice of intent and final distribution of assets, during which the plan’s funded status is still at risk. It’s critical to prevent new unfunded liabilities—such as market volatility risk—from popping up while you’re looking to administer the termination.

We can help

Whether your pension plan has been frozen for years or you’re seeking to terminate as soon as you can, the defined benefit team at Principal is there to help so you can meet your needs. 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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