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.