Asset Allocation for Defined Benefit Plans

The goal of a defined benefit (DB) plan is to provide the retirement benefits promised to retirees. Achieving sufficient investment returns will help to accomplish this goal and minimize cash contribution outlays. Asset allocation, the practice of dividing an investment portfolio among the major asset categories of equities, fixed income, cash equivalents, and appropriate alternatives, is a fundamental principle of sound investing. Diversifying an investment portfolio by including asset categories  whose returns respond differently to varying market conditions can help protect a DB plan a from substantial losses. This approach works because, historically, major asset categories have rarely gained or lost value simultaneously. A portfolio should be diversified both across and within asset categories. Effective diversification involves selecting investments within segments of each asset category that respond differently to market conditions. For instance, equity investments can be allocated among large-cap, mid-cap, and small-cap stocks, and further differentiated between growth and value stocks  

Determining the appropriate asset allocation model for a DB plan is a complicated task. No single asset allocation model is right for every plan. The challenge is to pick the mix of assets that has the highest probability of meeting the plan's goals, at an acceptable level of risk. (Many plans also implement a short-term tactical policy that is more responsive to changes in the financial markets). The state or local government plan sponsor’s risk tolerance, funding goals, funding policy and asset allocation should all mesh to form a cohesive strategy that will support the long-term affordability and sustainability of the pension plan. 

1. To lay the groundwork for developing an asset allocation plan, review and evaluate the following issues: legal framework and fiduciary standards; need for liquidity (the ability to convert an asset to cash quickly); tolerance for risk (the amount of expected volatility in the value of a security or portfolio); monitoring guidelines; and compliance procedures.
2. Work closely with actuaries and investment advisors to model the impact of asset allocation decisions on progress toward the plan’s long-term funding goals. To this end, the plan’s actuary will use sophisticated modeling techniques.¹ The following steps should be considered:
   1. Establish a plan funding goal. This may take the form of a statement such as: To achieve an X% funded ratio within Y years, with a probability of Z% (e.g. 100% funded ratio within 20 years, with a probability of 90%).
   2. Communicate level of risk tolerance to the plan’s actuarial and investment advisors. For example, plans with high short-term liquidity needs may be less able to accept a high degree of risk.
   3. Request (typically from the investment advisor) and review capital market assumptions for the various asset classes under consideration for the plan.
   4. Model future contribution requirements or other funding metrics achieve the stated funding goal, then choose the one that most closely aligns with the desired risk tolerance. If none of the asset allocations achieve the funding goal, consider changing the funding policy (and re-model).
   5. Once an asset allocation is selected, the actuary should recommend any updates to the assumed investment return. If a change is recommended, consider re-modeling to ensure goals are still met with the new assumption.
3. The result of the efforts described above should produce a long-term strategic asset allocation policy that would identify the broad mix of assets (equities, fixed income, cash equivalents, and alternatives) necessary to achieve the plan's funding and risk objectives. When determining the number of investments to be chosen, and their complexity, consider the ability of plan decision-makers to properly monitor the strategies.
4. Periodically review the portfolio performance to ensure compliance with the asset allocation targets. 
5. Avoid market timing (buying and selling securities based on an attempt to predict the future direction of the market). 
6. Report the results of the review to the governing body.