Amid the global recession in 2008 and 2009, pension plans' assets lost enough of their value that many defined benefit plans became significantly underfunded. From equity risks to interest rate changes, navigating volatile markets is a challenge for all pension plan sponsors. One spoke with Ari Jacobs, retirement solutions leader at Aon Hewitt, about how employers can manage risks in their pension investment portfolios.

Q: Aren't defined benefit plans on their way out?

A: Actually, they are a lot more common than most think. About two-thirds of large employers still have pension plans, and they are found across all industries, especially in the energy, utilities and manufacturing sectors. Of those employers with defined benefit plans, about half have open plans where employees continue to receive increasing benefits. This means that pension benefits remain an important part of the total rewards structure for many individuals. That's encouraging since defined benefit plans provide important value and offer unique protection that is difficult to replicate with other forms of compensation. But they are complex and need to be managed well by the plan sponsor.

Q: How were pension plans affected by the recession?

A: The global recession certainly took a toll on plan sponsors. Pension plans' funded status declined around the world. An Aon Hewitt analysis showed that the average funding levels dropped to as low as 72 percent for U.S. companies in late 2008 and early 2009. Recently, plans' funded statuses have been improving—up to levels of about 87 percent by the end of 2010. The main reason for the improvement in funding is recovery in equity markets and rising corporate bond rates—both of these are core components to a plan's funded status. As funding levels improve, it is critical for pension plan sponsors to start working on solutions to de-risk their investment portfolios and avoid some of the unrewarded risks and volatility of the past few years.

Q: So what are some risk management solutions that plan sponsors should consider?

A: First take the major investment portfolio risk: declining asset values that lead to underfunding. That situation carries a range of problems for pension plans. Underfunding below 80 percent of expected plan liabilities can trigger restrictions in benefits under the federal Pension Protection Act of 2006. Large and possibly unanticipated contributions to raise funding levels can force tough decisions and direct capital away from other business projects. Increased liabilities on a corporation's balance sheet can impact its credit rating and debt covenants. While seeking excess returns and investing in equities and other growth assets is important, a plan sponsor should manage that strategy and try to ensure that any risks are rewarding.

Increases in plan liabilities may also end up prompting reductions in a plan's funded status. These are often associated with movements in interest rates and can be hedged and controlled through focused investments in the fixed income markets. We recommend plan sponsors look at their asset/liability mismatch risk when developing their investment strategy to ensure they are considering both sides of the balance sheet.

Aon Hewitt studies on pension risks over the past three years show that dynamic investment policies have steadily grown in popularity among plan sponsors as a portfolio de-risking approach. These policies—also called glide paths—introduce new risk metrics by adjusting the plan's asset allocation as funding levels improve and as interest rates increase. Glide paths are a good way to transition investments when sponsors want to remove risk from the portfolio, and they enable sponsors to do that in a measured, planned way.