The coming crunch for pension plans: Derisking despite supply, low-rate issues

Many U.S. corporate defined benefit plans have engaged in strategies to narrow the mismatch between the interest rate sensitivity of their assets and liabilities. However, executives of many plans are waiting to take action. We believe three factors will conspire to put pressure on them.

nThe consensus view that long bond yields are set to rise may not be realized, and defined benefit plan executives might not be fully aware that waiting to derisk is an active bet that might not turn out in the way they expect.

nWhen the herd starts moving — i.e., when many defined benefit plans begin to invest in long-duration bonds at the same time — there will not be an adequate supply to meet demand.

nThe high level of demand for long-duration bonds will likely exert downward pressure on rates. With all things considered, defined benefit plans should reduce their liability mismatch now, rather than wait for interest rate increases to occur at some unknown future date.

When it comes to managing pension fund liabilities, money managers often hear: “Why hedge liabilities now, when the Federal Reserve is sure to raise rates?” Our response is that an increase in the fed funds rate does not always cause long-term rates to rise in tandem, as shown at left. The Fed controls the overnight rate, but pension liabilities are governed by long rates. As people live longer, soon-to-be updated mortality tables by the Society of Actuaries will cause the duration for pension funds to rise. This dynamic is likely to increase demand for long bonds further still, thus exerting downward pressure on long-term rates.

The three most recent instances of rising rates show the lack of correlation between increases in the fed funds rate and the 30-year yield. Between June 29, 2004, and June 29, 2006, the fed funds rate increased by 4.25 percentage points but the 30-year rate actually declined slightly, by 0.12 percentage point. We saw a similar disconnect in the period June 29, 1999, to May 15, 2000, when the Fed increased rates by 1.75 percentage points but the 30-year rate only increased by 0.05 percentage point. In the period from Feb. 3, 1994, to Feb. 1, 1995, the fed funds rate increased to 6% from 3%, but the 30-year rate only increased by 1.44 percentage points.

Financial theory helps to explain these superficially surprising results. When a change is widely expected by the market, prices tend to anticipate the change. In other words, investors must consider the possibility that the yield curve already has incorporated the expected rate hike. They may well be waiting for a train that has already been cancelled — the dispatcher just hasn't announced it yet.

Today, there is consensus that the Fed will raise rates — after all, Fed Chairwoman Janet L. Yellen has said so — but no one knows when. Is it advisable for pension plans to get into the business of making this market call? We would advise against it. Pension risk management is all about hedging; therefore, plans should not be speculating on the direction of interest rates.

Furthermore, while plans wait for rates to rise, the market is experiencing significant yield volatility. If that volatility kicks in at the wrong time, such as fiscal year-end, unhedged liabilities could soar and, as a result, financial statement volatility could increase.

Even if long-term rates do rise, we could be waiting a long time before that happens. This is a point that Curt Custard, managing director and head of UBS global investment solutions, UBS Global Asset Management, made in his July 30 paper, “A warning to bond bears” (read it at pionline.com/custard-paper). In that paper, Mr. Custard maintains that interest rates could stay lower for longer than the current consensus, and lower yields could lead to a rude surprise for investors convinced that yields are destined to rise.

What are the implications for U.S. defined benefit pension plans? For a typical plan hedged 75%, liabilities will grow faster than the fixed-income portfolio by about one percentage point annually, under current market conditions. This is not a scenario that plan sponsors will likely tolerate for long. We expect increasing demand for long-term bonds that will not be met by increasing supply. Therefore, we expect the cost of hedging pension liabilities with corporate bonds to rise. Plans that wait will find it more difficult to hedge, and more expensive.

As pension fund executives increasingly implement liability-driven investing strategies to manage their funds' liabilities, they are driving a massive increase in demand for longer-term corporate bonds to hedge their liabilities. In 2013, many unhedged plans saw their funding ratios improve dramatically, only to give back half their gains when markets shifted in the first half of 2014. To avoid adding to this disappointment, many plans are moving to “derisking” strategies, which also entail increased allocations to corporate fixed income as funding ratios improve. These derisking strategies are further driving demand for long-term credit.

Where is the supply to meet this increased demand? We estimate that U.S. corporate defined benefit pension plans represent about $2.3 trillion in liabilities. On the supply side, the long maturity credit market is valued around $1.4 trillion. New issuances at this end of the curve are expected at a pace of about $150 billion to $200 billion a year, not nearly enough to meet expected demand. If accounting requirements for public pension plans tighten further (we estimate public plan liabilities at $3.5 trillion), this demand problem could explode, with the gap between supply and demand potentially widening to $4.4 trillion from $900 billion. Plans that wait to put these hedges in place might well pay more for them. U.S. regulators should be urged to change plans' liabilities benchmark to government bonds from corporate bonds. If this change happens, we expect the supply/demand problem to move to the government bond market from the corporate bond market, possibly leading to an inverted yield curve.

There is a crowding problem here, too. If a plan waits to hedge until rates rise, it will be on one very crowded train. Not only pricing, but liquidity issues are likely to kick in. Economic theory suggests this crowding would depress yields further, another unpleasant surprise for those who assume that longer-dated yields are bound to move higher. Pension plans could experience a double whammy, as lower yields drive liabilities higher and funding ratios lower, at the same time drying up the supply of long corporate bonds that could help them hedge against further damage.

U.S. defined benefit pension plans that have not yet entered into a derisking strategy should design and implement one today. Plans that already have a program in place should adhere to their derisking schedule, regardless of their views on the direction of interest rates. Plans that take these actions can focus on reducing their long-term asset/liability mismatch, and worry less about a factor out of their control. n

Robert Guzman is managing director and head of pension risk management, and Neil Olympio is director and senior analyst within the pension risk management team, at UBS Global Asset Management in Chicago.