In the prior environment of rock-bottom interest rates, many defined benefit pensions were in deficit and focused on improving their funded status. Fast forward through a paradigm shift in interest rates to a world where many plans are overfunded and facing critical derisking decisions.
Derisking alternatives include reopening previously frozen plans, arranging an annuity buyout, placing a plan in hibernation, or immunizing a portion of a plan's liabilities.1
Our case study focuses on the latter and addresses the rationale, decision factors involved, portfolio construction, and management of an immunized bond portfolio for retirees.
Funding Conditions
During the post-financial crisis environment of rock-bottom interest rates, the funding levels on the 100 largest U.S. pension plans remained less than 100% for well beyond a decade. It even dipped below that threshold as recently as 2023 (Figure 1). However, the sizable appreciation in growth portfolios and the persistence of elevated liability discount rates lifted the plans' funding levels to 105% by the end of 2024.2 As this gradual improvement materialized, many plans took incremental steps to secure funding levels.
These steps included closing to new members, freezing services accrual, reallocating from growth assets to fixed income, and selectively transferring the risk of specific liability cohorts through insurance contracts.
The plan in this case study decided on a larger derisking step by fully immunizing their retiree population with a cashflow matched bond portfolio.
Figure 1
A prolonged path for the 100 largest U.S. plans to become fully funded* (%)
Source: Milliman. *The final two columns are Milliman estimates for year-end 2025 and 2026.
Rationale for an Immunized Bond Portfolio
While there were a number of derisking paths available, the plan's ultimate choice to create a cashflow matching portfolio, which would remain in the pension trust, was based on some important benefits:
- a pension trust is an efficient investing vehicle with trading and investing flexibility due to tax exemption and lack of investment-related capital implications;
- lower investing constraints create higher return potential from asset class selection, asset class rotation, security selection, and active trading;
- this can increase surplus over time and enhance the funding position of the liability;
- and accumulating surplus can facilitate the intake of additional populations from plan mergers or new retiree cohorts into the immunized portfolio.
Background and Decision Factors
The plan in our case study is relatively large (i.e., more than $5 billion in assets), remains open with accruing benefits, and the retiree portion consists of about half of the participants and about two-thirds of the liabilities.
With these characteristics as context, the plan's main objectives included the following:
- building a bond portfolio to match current retirees' next 30 years of projected benefit cashflows with investment grade corporate bonds and highly-quality securitized credit; and
- generating liquidity on a monthly basis to pay retiree expected benefit payments.
Furthermore, conditions for proceeding with the transaction were:
- achieving a minimum yield requirement, and;
- meeting the condition of sufficient asset coverage relative to the liability;
Portfolio Construction
An initial step in the implementation process consisted of constructing a model portfolio, which matched the liability cashflows and met the investment guideline constraints. The yield of the model portfolio was monitored daily. When both the yield trigger and coverage conditions were met, the rotation from the original, growth-heavy portfolio to the cashflow matching portfolio began.
Ramp-Up Phase
Once the liquidation of the growth assets began, it was paramount to hedge the model portfolio yield—and its most volatile components of interest-rate and spread risk—quickly. Given the size of the transaction, a broader set of derivatives and ETFs were permitted and a credit facility was established to facilitate efficient execution.
The sequence of milestones to progress from the initial risk factor hedging portfolio to the fully cashflow matched portfolio were as follows:
- by the end of the first day, the interest rate risk of the cashflow was hedged;
- by the end of the first week, the spread risk of the model portfolio was hedged;
- by the end of the first month, the spread risk of the portfolio was transitioned from synthetic to physical exposure;
- over the remaining five months, other sectors with lower, secondary market liquidity or slower primary issuance were gradually selected;
- as the bond portfolio was gradually constructed to match each year's individual cashflows, the desired industry, issuer exposures were established with specific bonds.
Portfolio Management and Measurement of Success
Once the portfolio ramping phase concluded, ongoing management began with a new, more constrained set of guidelines focusing on active security and sector selection.
Ultimate success of the transaction will be achieved by the portfolio paying all of the expected cashflows for the projected 30 years of the immunization. The progress towards this goal can be measured by monitoring the funded status of the liability. This provides a measure of how well the portfolio value covers the liability at any point in time.
Additionally, a custom market index was created, which provides a yardstick for measuring the value added through the asset manager's active portfolio management. The custom index is reweighted periodically as the liability rolls down over time.
This dual approach of funded status monitoring and creation of the custom index provides governance over both the ultimate objective for the portfolio to deliver benefit payments to the participants and the manager's ability to add alpha through active management.
Conclusion
Market conditions have brought the funded status for many pension plans to elevated levels. Plans that are looking to de-risk, while maintaining future flexibility, can consider an immunized bond portfolio for retiree liabilities, and this case study demonstrates that modern approaches to cashflow matching portfolio construction can achieve efficient execution for large transactions.
1 Annuity buyouts are also referred to a pension risk transfers (PRTs)
2 According to the Milliman Pension Funding Index.
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Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of January 2025.
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