Rising interest rates improve pension funding, but create new problems

Corporate pension plans with liability-driven investing strategies have finally begun to see the light at the end of the tunnel: soaring funding ratios.

Still, many pension executives are betting on further increases in rates and equity markets before implementing asset allocation changes along their derisking glidepath.

Rising interest rates and strong equity markets have increased the funded status of S&P 1500 companies' pension plans to 88% at the end of June, a 14-percentage-point increase year to date and the highest level since October 2008, according to Mercer LLC.

“We have had more than 50 clients hit their (funded status) triggersin the first six months of 2013, about the same number (combined) that hit triggers in the previous three years,” said Richard McEvoy, New York-based partner and leader of Mercer's financial strategy group. “In general, the trend is accelerating, as more than half of those that hit their triggers in 2013 did so in the second quarter of the year.”

Glidepaths are constructed as a guide for pension plans to reallocate more assets into liability-hedging investments as higher funded status marks are hit. Some plans also use interest-rate triggers to reallocate when rates reach certain levels.

An estimated 75% of U.S. corporate plans use some form of LDI, and there is “absolutely” a capacity issue for long-duration bonds, said David Wilson, managing director, customized strategies, at Cutwater Asset Management, Armonk, N.Y. Because interest rates rose about 100 basis points this year, many plans hit different trigger points at the same time, he said.

Mr. Wilson said with more than $19 trillion in retirement assets and a significant demographic shift toward retirees, and in turn more fixed-income investments, “you have a big-time supply-and-demand imbalance in long-duration fixed income.” He added there is about $2.1 trillion in outstanding bonds that are investment-grade and maturing in 10 years or more.

There has been an approximately $120 billion per year supply of long-duration corporate bond issuances, and demand from corporate defined benefit plans alone could account for that, said Michael Moran, managing director and pension strategist at Goldman Sachs Asset Management, New York.

But many plans are hesitant about getting into long bonds now with rates expected to rise further and growth portfolios delivering such strong returns.

“There's a lot of psychology involved in the management of pension plans,” Cutwater's Mr. Wilson said. “When equity markets perform as (they are) and rates are rising … I think plan sponsors are trying to take advantage on a return basis and the desire to derisk subsides a bit.”

There seems to be more interest in reducing risk following a stock market decline, Mr. Wilson said. “I equate it to buying an umbrella after it rains,” he said.

Most clients automatically reallocate their plan assets when they hit a funded status trigger, but Mercer is still seeing larger plans not getting out of equity or other growth investments despite the improvements along their plan's funding glidepath, Mr. McEvoy said. Many companies that do not delegate glidepath discretion to a manager or consultant will not make moves until a monthly or quarterly board meeting.

Plus, corporate pension plan executives failed repeatedly in the past to lock in a high funded status before that funding level quickly eroded from falling stocks and/or interest rates.

Mr. Wilson said Cutwater generally recommends hard triggers and points to the summer of 2011 as a prime example. The average funded status was 91% on June 30, 2011, he said, only to plummet to 77% by the end of August on the heels of the European debt crisis and U.S. debt ceiling debates. He estimates about 25% of plans were using some kind of LDI strategies at that point.

“It shows how quickly funding ratios can turn for you or against you,” Mr. Wilson said. “We use the 2011 example all the time as an opportunity lost.”

GSAM's Mr. Moran said that in the past few months, clients have been hitting their funding triggers for the first time in a couple of years, and there has been a wide disparity among plans either implementing changes or waiting for still more funding improvement.

“One thing we are telling clients is if a glidepath was put in place two, three or four years ago, there was probably a good reason to do that … and that reason is still applicable today,” Mr. Moran said. “The whole glidepath process is to take a view on rates out of the equation. That way you do not have to make a call on interest rates.”

When making client presentations, Mr. Moran uses a cautionary tale about a pension plan he declined to name that was 108% funded with a 67% allocation to equity in 2007 that found itself 74% funded the next year.

“It's almost like a scare tactic,” Mr. Moran said. “It's amazing how many clients I show that slide to and they say, 'that was us.'”

Mr. Moran said corporate executives can have a risk management view of their plan or an investment returns view, but it is difficult to combine them.

Executives at Russell Investments make it a point to constantly remind clients that the gains in funded status from a rising discount rate outpace the asset losses from a traditional fixed-income portfolio, and plans using a glidepath should not worry about benchmark returns, said Martin Jaugietis, New York-based managing director, LDI solutions. Russell automatically transfers assets along the glidepath for clients that grant full investment discretion.

But not all investment consultants recommend automatic triggers. For example, SEI Investments, Oaks, Pa., supports looking at market outlooks and individual client situations before making reallocation recommendations, said Jon Waite, chief actuary and director, investment advice.

“If markets are not as liquid, maybe it's not a good time to get fixed income,” Mr. Waite said. “It's not just about leaving it up to the computers.”

Executives at SEI client National Grange Mutual Insurance Co., Keene, N.H., believe the long-duration component in the company's $118 million open pension plan has been “extremely successful in helping hedge that liability,” said Thomas Frazier, chief investment officer. However, the plan actually decreased its long-duration allocation to 23% from 28% on June 1 to take advantage of current markets despite the plan being more than 110% funded. At the same time, it is lowering risk in the equity portion by moving 24% of assets into domestic and global managed-volatility strategies.

Money manager sources said each plan has a unique situation, and that frozen and closed plans are more likely to adhere to their glidepaths. The size of the pension liability compared to the overall corporate balance sheet also plays a large part in how comfortable plan executives might be with their growth portfolio, Russell's Mr. Jaugietis said.

Another solution is investing new contributions directly into LDI so as not to sell off equity holdings, said Gary Knapp, managing director, LDI strategies, for Prudential Fixed Income.

National Grange's Mr. Frazier said the relatively small liability size gives his plan more flexibility to take risk. However, NGM Insurance also administers two underfunded, frozen plans of companies it acquired, with about $25 million in assets each. Those plans are on a more direct LDI glidepath with the end goal to reach about 110% funding to execute a full pension buyout, Mr. Frazier said. He anticipated it will be a couple of years before that happens.

Many SEI clients are accelerating their pension contributions to reach the end game of a risk transfer, such a lump-sum cash-out or buyout, Mr. Waite said, a trend that is emerging throughout the corporate world.

“I think the trend we're seeing is LDI strategies the last couple of years, (then) voluntary cashouts. The next shoe to drop is on annuity buyouts. Risk transfer is the next big thing,” Mercer's Mr. McEvoy said.

According to a Mercer survey released last month, 67% of corporate executives said they are somewhat or very likely to offer cashouts to former employees, and 48% are somewhat or very likely to do an annuity buyout over the next two years. According to the survey's estimates, as much as $100 billion could be involved in annuity purchases over the next two or three years. Forty-six percent of respondents were from plans with more than $1 billion in assets.

Prudential's Mr. Knapp echoed that sentiment. He said as plans push into the 90% funded range, they are starting to gather more information about the costs of risk-transfer strategies. He added that with new mortality tables likely coming out at the end of 2015 or 2016 that are expected to show average lifespans getting longer, risk transfers will become more expensive as well.

“I think ultimately a lot of (corporations) want out of their pension plans,” Mr. Knapp said.

Annuity buyouts, as well as lump-sum payments, are long processes, and even with significant jumps in funded status in the last several months, it's unlikely there will be large deals this year unless the planning process was already underway.