Pension funding levels dropped by nearly 10% last month, in an environment reminiscent of the falling interest rates and declining equity markets from 2000 to 2002.
November was a perfect-storm month, said Aaron Meder, head of asset and liability investment solutions for UBS Americas division, Chicago. During the month, interest rates dropped about 40 basis points and investment returns for those plans dropped 2%, due largely to a 4% drop in the U.S. stock market.
Those changes caused the funded status of a typical pension fund among Standard & Poors 500 companies to drop to 100% from 109%. The typical plan was 113% funded at the end of June, according to UBS.
Whether you want to call it a perfect storm or not, its very similar to what happened from 2000 to 2002, Mr. Meder said.
Similarly, BNY Mellon Asset Management, Boston, found the funded status of the typical U.S. defined benefit plan declined 7% in November. That means the funded status of the typical plan has now deteriorated by 2.7% for the year to date.
Current Wall Street clamoring for lower interest rates could fall under the category of watch what you wish for or you might get it, said Robert Arnott, chairman of Research Affiliates LLC, Pasadena, Calif.
Closer monitoring needed
Experts including Mr. Arnott dont predict the same catastrophe that occurred at the beginning of this decade.
For one thing, interest rates cant fall as much as they did then because they are already so low, said Michael Peskin, managing director and head of integrated pension solutions at Morgan Stanley Investment Management, New York.
The 10-year Treasury yielded roughly 6.7% in 2000, and dropped to roughly 3.5% during that time period. Right now, the 10-year Treasury is around 4%. Its highly unlikely rates will go down 300 basis points, Mr. Peskin said.
For another, the stock market also is not as stretched now as it was in 2000, added Alan Glickstein, a senior actuarial consultant in the Dallas office for Watson Wyatt Worldwide.
This time it doesnt feel like weve had a market frenzy driving stocks up it feels more like normal economics, Mr. Glickstein said. The tech boom didnt feel like normal economics at all.
Fred Dopfel, managing director and head of the client advisory group of Barclays Global Investors, San Francisco, said pension executives need to pay better attention to their surplus position, which is the amount by which assets exceed liabilities. Pension surplus swings tend to be more volatile than the funding level.
Its kind of interesting that everyone talks about the assets and they dont talk about their surplus position, said Mr. Dopfel. People arent keeping track of that and perhaps they should People need to watch the surplus more frequently so they understand true volatility and whether that volatility is acceptable for them.
After reviewing volatility levels, he said most pension executives should consider a liability-driven investment-based approach. That typically involves shifting the asset allocation to fixed income and away from equity or lengthening the duration of the plans fixed-income portfolio.
Pension executives have learned some lessons from the perfect storm period and have changed their funds portfolios in order to avoid another one, added Kurt Winkelmann, managing director and head of global investment strategy for Goldman Sachs Asset Management, New York.
Mr. Winkelmann said that since 2002, he has witnessed three main investment themes: pension funds have reduced their exposure to equity; they have increased their allocations to alternatives so they can still receive higher returns if the equity market tanks; or they have adopted more strategies that hedge interest-rate exposure to their liabilities.
While most pension funds have not done all three of those things, nearly every one he is familiar with has done at least one. Since the events of the perfect storm, plans have really embarked on a rethinking of their investment policy, Mr. Winkelmann said.
While some corporate funds have adopted investment strategies to hedge against interest-rate changes, Morgan Stanleys Mr. Peskin pointed out that many public fund executives could be shocked if interest rates and stock values decline together.
Regulations have forced corporate defined benefit plans to use mark-to-market accounting to calculate their funded status, and liabilities are listed on the corporate balance sheet. That has led corporate plan executives to think more about how sensitive their liabilities are to interest rate drops, and many of those plans have changed their investments accordingly.
For corporates, meeting an expected rate of return is no longer the bogey its matching or outperforming liabilities, Mr. Peskin said. However, many public plans are still trying to reach return targets and have not de-risked like the corporate plans, Mr. Peskin said.