Tuesday, August 27, 2019

Investment Insights

Pension Investing

Understanding the 'Death Spiral'

By Thomas Cassara/River and Mercantile Solutions

Many public sector pension plan sponsors face unique challenges which need to be reflected when establishing an appropriate asset allocation:

  • Funding ratios less than 100%;
  • High levels of annual cash outflows (benefit payments often over 5% of the plan’s market value); and
  • Limited ability/desire to materially vary cash contributions from year-to-year.

Given these challenges, Trustees should develop investment strategies that improve the funded status in a predictable manner and avoid having the plan become underfunded to the point where the plan falls into a “death spiral”.

The ‘Death Spiral’

At a high level, a death spiral can occur when an underfunded plan has negative cash flow. This is more common in mature plans where benefit payments plus expenses exceeds the investment income and contributions entering the plan. This negative cash flow typically causes the level of assets to fall and leave the plan with fewer assets to earn excess investment returns. This becomes especially pronounced in falling markets. Eventually, the decline in asset value and funded status becomes substantial and a severe action needs to occur in the form of higher cash contributions, lowering future benefit payments or a combination of both. The following two exhibits show this point.

Figure 1 illustrates the projected funded status over 10 years for a sample open pension plan that is currently 60% funded, with relatively high annual benefit payments, new contributions entering the plan and assumed to earn 6% a year.

Even though this plan is making contributions and is earning the assumed liability return it is projected to be less than 45% funded 10 years from now. While most plans are above 60% funded today, any material longer-term market correction could leave many pension plans at or below 60%.

What investment return is needed?

Figure 2 shows the approximate annual rate of investment return needed to maintain the current funded status for a similar pension plan to the one described above. As an example, the above plan needs to earn 9% per year to maintain its current 60% funded status, a full 3% above the assumed 6% return, even after taking into account the 3% contribution.

As the above illustration demonstrates, the worse funded the plan is, the higher the investment return needed to maintain the current funded status, let alone to improve upon it.

As a result, plan sponsors and Trustees who have poorly funded pension plans need to invest not just to earn these rates of return but also to “protect” the plan as best they can from falling into the death spiral. These spirals are especially painful because a fall in funded status will most likely occur during a recession when the ability to increase revenue from tax payers is likely to be limited.

An example of a “death spiral” was seen during the recent financial crisis, where the level of funded status for state public plans went from an average of 92% funded in 2007 to 61% in 2009 according to a study by Wilshire. These plans had to sell off assets during the crisis in order to raise cash to meet required benefit payments and as a result had fewer assets with which to participate in the subsequent market rebound.

Considerations in Setting the Investment Approach

Given the characteristics of these plans and the heightened risks they face due to less than optimal funding ratios, we believe Trustees need to consider these factors in defining their portfolio allocation. Consideration should be given to future results under a diverse set of economic scenarios, especially those that can most likely lead to a death spiral.


A vast number of pension plans rely on diversified portfolios dominated by global equity allocations and a significant percentage of alternative investments (hedge funds, private equity, private debt), yet funding ratios have remained stagnant even in the face of the longest equity bull market in history. We believe that an investment strategy which encompasses more predictable returns and increases protection against shocks to its funded ratio via a recession or economic downturn is most prudent for plans to consider on behalf of their participants.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of River and Mercantile Solutions nor TEXPERS, and are subject to revision over time.

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