Digging out from hole of pension underfunding

With no market boost seen in 2013, execs hold to course

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Cardano's Phil Page: "It's almost gotten beyond the point where investment alone can be the solution."

Pension executives will continue to rely on creative investing, higher contributions and pension buyouts or lump sums to make any improvements in funded status in 2013.

Markets won't likely offer much respite to underfunded pension plans globally, as experts see tepid investment returns and stagnant yields on bonds used to calculate liabilities in the year ahead.

“We've brought our (long-term return expectation) numbers down a little bit, but that's primarily an issue with the starting position” as most asset classes have rallied in 2012, said Michael Feser, managing director and head of quantitative research and portfolio management for J.P. Morgan Asset Management (JPM)'s global multiasset group, New York.

For example, annual return expectations for U.S. large-cap equities will fall to 7.25% in JPMAM's forthcoming capital market assumptions, down from 8% a year prior. Expected returns on international stocks are unchanged at 7.5%, while expectations for emerging markets stocks dropped to 9.75% from 10%.

“I fully think it will be a challenging year” for investments, said Stephen Wood, chief market strategist, North America, at Russell Investments, New York. Russell could not provide capital market assumptions for 2013, but Mr. Wood said perceived riskiness of markets will continue to depress yields on the safest government and corporate bonds used to price pension liabilities. “I'm not convinced there'll be tremendous change in that,” he said.

“Markets are the big uncertainty,” said Phil Page, client manager at fiduciary manager Cardano Risk Management BV, London. “In most scenarios, we think equities can go up from here (and) deliver 6% to 7% per annum returns over the next few years, but it might be quite a bumpy ride.”

Institutional investors in Europe, while being “cautiously optimistic for 2013,” do rate investment volatility as a major risk in the year ahead, according to an October survey by search consultant bfinance.

“Asset price collapse” and “asset price volatility” were among investors' biggest concerns for the year ahead: 85% cited collapse — and 80% cited volatility — as a significant risk, with 26% and 28% of respondents having plans in place to deal with a market crash or volatility, respectively, according to the survey of 54 primarily European institutional investors with combined assets of nearly $350 billion.

Meanwhile, investment experts do not expect the yields on bonds used to calculate pension liabilities to rise from very low levels for up to three years. And it's in the area of liabilities that pension funding has been hit the hardest.

Among U.S. plans, aggregate funded status fell three percentage points to 75% in the 10 months through Oct. 31, despite an equity rally of 14%, according to J.P. Morgan Asset Management.

Persistent rock-bottom interest rates and investor flight from volatile equity markets have pushed down returns on the safest assets, pushing up costs on derisking programs such as liability-driven investing. That's left pension executives searching for new ways to meet return expectations or lower funding shortfalls, such as pension buyouts and lump sum distributions, which will continue in 2013.

Obligations grow

Pension obligations as a percentage of market capitalization for the average U.S. corporate plan sponsor grew to 26% as of Oct. 1, up from 22% at the end of December, according to J.P. Morgan Asset Management (JPM)'s most recent “Pension Pulse” publication. Five percent of U.S. firms have a pension deficit that's more than half of the size of their company. These factors will lead companies to extend “the range of their derisking strategies, including lump sums and buyouts alongside contributions and asset allocation changes,” according to the publication.

“On both sides of the Atlantic, there's been an unwillingness to accept the risks that we've been running within the industry for years and years,” in part because pension executives got used to being bailed out by market returns, Cardano's Mr. Page said. He predicts U.K. pension plans' funding levels to improve by only one or two percentage points in aggregate over the next year.

“It's not the sort of progress that's going to get you to fully funded in 10 years or even 20 years,” he said. “It's going to be very, very slow improvements, and it will be contributions that will be a major help. It's almost gotten beyond the point where investment alone can be the solution.”

The $4.9 billion Missouri Local Government Employees Retirement System, Jefferson City, has adjusted investments to minimize the need to change its return assumptions. The plan has kept its expected 2.5% real rate of return from its fixed-income portfolio constant, but with U.S. Treasuries offering negative real yields, “that's a problem,” said Brian K. Collett, chief investment officer.

So Mr. Collett has gotten innovative to come up with “yield with real underwriting,” he said, such as by making direct investments in midmarket bank loans. “These aren't riskier investments, they're just different.”

However, Missouri Local's board is also considering whether its overall return assumption should be lowered; currently at 7.25%, it was lowered from 7.5% in 2010. If it were to lower its return target, the system would join scores of other public plans in the U.S. doing the same: the average actuarial assumed rate of return fell to 7.84% in 2011 from 7.96% in 2007 (Pensions & Investments, Oct. 1).

Also, corporate plan sponsors in particular are scrambling to take out risk wherever they can, including by boosting contributions.

Since 2009 in the U.K., the largest 100 public companies have made their largest pension contributions in history. In 2011, about half of the 21.4 billion the firms contributed went to deficit reduction, investment consultant Lane, Clark & Peacock said in July.

While the U.K. Pensions Regulator has given corporate plan sponsors some leeway in filling funding gaps, “on the other hand, companies are seeing pension funds as a big problem, and they want to just close down the problem,” Cardano's Mr. Page said. “So there is a general increase, even now, toward larger contributions.”

Contributions from S&P 1500 companies to their defined benefit plans in 2013 might well have risen 25% to about $100 billion from expected 2012 levels, said Jonathan Barry, Boston-based partner at investment consultant Mercer. “However, that number will go down because of funding relief” passed this summer as part of the MAP-21 highway law, Mr. Barry said. “Next year we'll probably see funding at a higher level than in 2012, but it's hard to say how much.”

Ever-lower bond yields hit pension plan funding levels hard in Europe as well as in the U.S. and U.K.

“Bond yields have stamped out the benefits of investment returns of about 7% for Swiss pension funds,” said David Pauls, director and head of retirement solutions in Switzerland at Towers Watson & Co., Zurich. “More has been lost on the liabilities side than has been gained on the asset side.”

To compensate and reduce liabilities, Swiss pension funds have reduced pension benefits levels, and are starting to require participants to take a portion of their benefits as a lump sum at retirement, Mr. Pauls said.

Swiss and German funds are looking to move as closely to a defined contribution-style as regulations will allow and are separating death and disability benefits — traditionally part of pensions in these countries — from the core of retirement funding.

Large German corporate pension funds “are looking to derisk, but at the same time they are trying very hard to stay attractive,” something supported by both demographic changes and workers' desires for retirement funding to be handled by their employers, said Thomas Jasper, director and head of retirement solutions for Germany at Towers Watson, Wiesbaden.

Russell's Mr. Wood did offer some hope amid the gloom and doom of most forecasts: Positive outcomes to three macro risks could boost global growth in 2013, sending equity markets sharply higher.

But that would require: a true, bipartisan equilibrium to be found on the fiscal cliff issue facing the U.S. government; China to move its economy to one with greater domestic demand while avoiding major growth declines; and a clear path to resolving the European debt crisis, according to Mr. Wood.

“For all the problems Europe will continue to have, there was at least rudimentary agreement to a banking union” across the European Union this summer, Mr. Wood noted. “That could be a very first credible step toward a "United States of Europe' - a very positive and non-trivial step forward.”

This article originally appeared in the November 26, 2012 print issue as, "Digging out from hole of pension underfunding".