The Pension's Glide Path and the Denominator Problem
A $400 million corporate defined benefit plan is 88% funded on a liability-driven basis. The plan sponsor wants to reach full funding within five years and then de-risk. The current allocation is 55% global equity, 30% core bonds, 10% private equity, and 5% real estate. The liability discount rate is 5.2%, the plan's expected return assumption is 6.8%, and the sponsor contributes $12 million per year. Equity volatility is 17%, bond volatility is 6%, and the correlation is 0.15. The investment committee wants to add 10% to private credit, funded from core bonds, to "increase yield without adding equity risk."
1. Evaluate the proposed private credit allocation against the plan's funding objective and de-risking glide path.
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The proposal must be evaluated against the liability, not against a standalone yield comparison. Moving 10% from core bonds to private credit raises expected return modestly but changes the hedging properties of the portfolio: core bonds have duration that offsets liability moves, while private credit has credit spread duration and equity-like drawdown behavior in stress. The plan's funded status is sensitive to the spread between asset returns and the 5.2% liability discount rate; replacing duration-hedging assets with credit assets increases funded-status volatility even if total portfolio volatility is similar.
The committee should quantify: (1) the change in funded-status volatility, not just asset volatility; (2) the liquidity profile, since private credit is illiquid and the plan has a five-year de-risking horizon; (3) the fee drag, since private credit fees are typically 1-2% versus 0.05-0.15% for core bonds. If the plan is on a glide path to de-risk at full funding, adding illiquid credit at 88% funding is directionally wrong unless the credit sleeve is small and the duration gap is separately closed with Treasuries or long credit.
Recommendation: reject the proposal as framed, or approve a smaller allocation (e.g., 5%) only if the plan separately extends duration with long Treasuries to keep the hedge ratio constant. Document the analysis.
2. The sponsor wants to reach full funding in five years. What return is required, and is the 6.8% assumption defensible?
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Required return is the return that closes the 12% funding gap over five years given $12 million annual contributions on a $400 million plan. The gap is $48 million (12% of $400 million). Contributions total $60 million over five years, but they arrive over time and the liability grows at 5.2%. A rough calculation: the plan needs assets to grow at a rate that, combined with contributions, closes the gap against a liability growing at 5.2%. If the liability is ~$455 million (400/0.88), it grows to ~$586 million in five years at 5.2%. Assets of $352 million plus $60 million of contributions plus investment return must reach $586 million. That implies roughly a 5.5-6.0% return on assets, not 6.8%. So the 6.8% assumption is not required to hit the target and is arguably aggressive.
The advisor should recommend lowering the expected return assumption toward a building-block estimate (bond yield plus equity risk premium plus alternatives premium, net of fees), which for this allocation is likely 5.5-6.5%. A lower assumption raises reported liability and contribution requirements but improves transparency and reduces the risk of a funding shortfall. The committee should also consider a contribution policy that increases if funded status falls below a threshold.
3. Design a de-risking glide path with triggers, and explain the denominator effect the committee should anticipate.
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Glide path. Define funded-status bands with target allocations. At 88-95% funded: 50% growth, 50% liability-hedging. At 95-100%: 35% growth, 65% hedging. At 100-105%: 20% growth, 80% hedging. Above 105%: 10% growth, 90% hedging. Triggers should be evaluated quarterly on a smoothed funded-status measure (e.g., 3-month average) to avoid whipsaw, and the glide path should be written into the IPS with pre-approved rebalancing authority so the committee does not have to meet in a crisis.
Denominator effect. As funded status improves, the plan's growth assets become a smaller share of a larger asset base, and the liability-hedging assets grow. But the reverse happens in a selloff: if equities fall and funded status drops, the glide path may call for more growth assets just when liquidity is scarce, and illiquid private assets (PE, real estate, private credit) may be marked down less than public equities, mechanically increasing their share of the portfolio. The committee should set rebalancing rules that use public assets for liquidity and avoid forced sales of illiquid assets, and should monitor the private-asset share against policy bands. Document the smoothing methodology and the liquidity buffer (e.g., 5% in cash and Treasuries) that funds rebalancing.