Corporate pension plans slow to adopt derisking

Updated with correction.

Many corporations have not moved to derisk their pension plans, leaving them vulnerable to widening funding deficits if equity markets and interest rates decline, according to asset management strategists.

“We still think we are in the very early innings of this (derisking) because clearly a number of plans have not made these shifts” to fixed income to match the duration of pension obligations, said Michael A. Moran, pension strategist, Goldman Sachs Asset Management LP, New York.

“There are a number of what I'd call headwinds ... (as to) why they haven't,” he said.

The aggregate asset allocation across the 50 companies with the largest pension funds in the Standard & Poor's 500 stock index was about the same at the end of 2013 as it was at the end of 2012, Mr. Moran noted.

But the relatively static allocation “masks some movement,” Mr. Moran said.

For the first time in his analysis — which started in 2003 when financial reporting rules required disclosure — the target asset allocation to fixed income (41%) exceeded that of equities (40%), based on preliminary 2013 data, Mr. Moran said.

In addition, some plans actually “made notable shifts,” he said, singling out Bristol-Myers Squibb Co., Duke Energy Corp. and Ford Motor Co.

But given “that equities massively outperformed fixed income last year ... many plans may be underallocated to fixed income if they operate under a glidepath strategy” in derisking, Mr. Moran said.

Many plans are holding off rebalancing and derisking because of continuing low interest rates.

“Some plans have a very strong view on interest rates,” Mr. Moran said. Executives at these plans say, “Rates are going to move higher and therefore why do I want to buy fixed income today? I'd rather wait this out.”

Rafael Silveira, vice president, portfolio strategist, institutional asset management, J.P. Morgan Asset Management, New York, said, “The liability-driven investing idea is pretty much ingrained in the pension management community” in terms of an eventual expectation of moving to it.

But while “there are plans that are moving along the glidepath” to derisking, others are “trying to wait a little bit until the entry point on the fixed-income front is more attractive,” he said.

Both men expressed similar views to an expectation of David R. Wilson, managing director and head of the institutional solutions group, Nuveen Asset Management LLC, Chicago: “As rates rise, institutional investors are pouring into fixed income.”

“There are psychological barriers,” Mr. Wilson said, such as 10-year Treasury yields rising to about 5%.

The yield on the 10-year Treasury bond, which ended 2013 at 3.03%, has been falling this year, Mr. Wilson said. It was 2.54% as of May 21, according to Department of the Treasury data.

Because of the yield advantages, plan executives seeking to derisk prefer long-duration corporate bonds rather than Treasuries, which are used to price yield spreads based on risk, Mr. Wilson said.

Pension fund demand for long-duration corporate bonds could rise to between $500 billion and $600 billion in total over the next three or so years, Mr. Moran said. Mr. Wilson estimates the demand at a cumulative $1 trillion over the next five years.

As corporations step up their derisking, demand could strain supply.

“For now we see a little bit of friction where the demand could be a little bit higher than what the supply is,” Mr. Silveira said. “That market basically corrects itself over time.”

Corporations ended 2013 with their plans showing increased funding levels across the board, Mr. Moran said.

In aggregate, the funding level of the 50 plans rose to 91% from 78%. The increase ranged from one percentage point for FirstEnergy Corp. to 28 percentage points for Merck & Co. Inc. All but 10 of the companies showed double-digit increases in their funding level.

Executives at some plans used the rise in funding to shift more to fixed income, Mr. Moran said, but added, “I can't give precise percentages of who's moving, who's not moving, who's rebalanced and who hasn't rebalanced.”

Among those that have not, “I think for many of them it's a question of when, rather than if,” Mr. Moran said.

“For a lot of the plans that aren't moving (to fixed income) today, it is because they have a view on rates” that would prompt them to hold off in the current low environment, Mr. Moran said.

The pension funds “have more potential funded status volatility because their assets are not as aligned with liabilities as they could be.”

“If I have a lot of equity exposure, I have a lot of equity risk ... and I also have a mismatch with my liabilities, which have a lot of interest-rate risk,” Mr. Moran said.

“The whole point to the (derisking) glidepath is as you improve your funded status, you want to reduce that volatility and you do that by shifting out of equity or (other) return-seeking assets and more into long-duration fixed income.

With improved funding, plans are better positioned to derisk.

“Whether (a company) can withstand the (funded status) volatility is a function of the materiality (to the corporation) on a plan-by-plan basis. There is a tension between the risk management view ... and the investment view” at companies, Mr. Moran said. The risk management view seeks to hedge the liability as funding improves. The investment view seeks to postpone moving into long-duration bonds if interest rates appear to be headed higher.

“I'd say those (companies) where the plan is very material to the organization have a greater incentive to take more of a risk management approach and say, "We are going to focus on asset-liability matching.'”

If it's less material, “maybe ... they are comfortable having that volatility,” he said.

For materiality or importance, Mr. Moran compares the value of a company's total pension obligation to the company's market capitalization. The higher the percentage of obligation to market cap, the more material funded status volatility might be to the company and the more vulnerability the corporate balance sheet would be to that volatility, Mr. Moran said.

Corporations have other reasons for deferring derisking ambitions.

New mortality tables that will be incorporated into corporate plans next year could raise liabilities 4% to 6%, Mr. Silveira said, noting that having growth assets can help mitigate those risks.

Mr. Moran estimates the new mortality tables could raise liabilities by more, between 5% and 10%.

“It's going to directly lower funded status,” Mr. Moran said. “That's what I'd call a headwind.”

This year has been a great example of funded-status volatility, Mr. Silveira said.

“We saw this improvement (in funding levels) in 2013. ... But since the beginning of the year, there has been some volatility. Our numbers actually show the average funded status going down,” Mr. Silveira said.

Even though “corporate pensions have lower allocations to equities than in the past,” Mr. Wilson noted, they “still maintain significant exposure and are thus quite vulnerable to greater volatility in certain markets and also have virtually a zero correlation to pension discounting curves.”

Corporate plan sponsors “have certainly derisked since the 70/30 allocation days pre-2006,” and now have generally 57% in return-seeking and 43% in fixed-income assets, Mr. Wilson said.

“During the last few years, more and more plan sponsors have adopted glidepaths ... but many insist on having continued discretion over the rebalancing decision,” Mr. Wilson said in a follow-up e-mail. “This discretion allows their market biases” — such as holding off change — “to factor into the derisking decision. As a result, many plan sponsors' fixed-income allocations ... are lower than they should be in my opinion.”

But “many plan sponsors have been aggressively derisking by allocating to long-duration bonds and derivatives since June 2013. I think this activity will continue since we just had a robust year for equities and many expect moderate returns and more volatility this year.“ When “rates rise, I anticipate that the pace of derisking will accelerate further,” he said.

Even so, Mr. Wilson said in the interview that funded status held up fairly well this year, proving the value of derisking strategies.

He estimates funded status among all corporate plans is about 90%, down from about 95% at the end of 2013. “Funded ratios have hung in there ... not a very dramatic drop-off,” Mr. Wilson said.

Expectations of rising demand for long-duration fixed income over the next five years raise concerns about the capacity of the market to have enough supply, Mr. Wilson said.

“There will be early adopters ... who recognize the looming supply issue and act now or in the near term,” Mr. Wilson said. “Those that wait might struggle to find (quality) bonds, or the bond that they do get will have a lower credit spread than they do today.

“Our prediction of the 10-year Treasury (rate) for the end of this year is 3.25%,” Mr. Wilson said, adding the rate might be too low for some corporate pension executives.

Mr. Silveira said many corporations “are waiting for normalization in the fixed-income market ... for the 10-year (Treasury) yield to be closer to long-term averages ... around 4%.”

Some plans are waiting for a “more attractive entry point” in fixed-income rates to derisk, Mr. Silveira said. To do so, he said, “you will have to stomach this volatility.”