Corporate pension funds weigh derisking vs. re-risking

Corporate plan sponsors on both sides of the Atlantic are pushing back against the ramifications of lower interest rates, tipping a balance to re-risking from a derisking glidepath, say money managers, consultants and strategists.

Continued low — and in some cases negative — interest rates across the globe are battering pension funding levels. Add to that changes to mortality tables and increasing Pension Benefit Guaranty Corp. premiums in the U.S., and the result is corporations are considering a number of strategies:

• hitting pause on their derisking strategy;
• re-risking their asset allocation;
• selling debt to finance pension contributions; and
• continuing to transfer retiree pension liabilities to insurance companies.

“One of the impacts that we have seen over the last few months of quantitative easing in the U.S. has been to lead some pension funds to consider re-risking, rather than derisking,” said Tony Gould, New York-based managing director and head of the pensions solutions group at J.P. Morgan Asset Management. “We have been having a number of conversations with plans thinking that. (They are considering) reducing liability hedges, and increasing allocations to return-seeking assets. That is starting to filter through on (the other) side of the pond,” especially, he said, as Europe's economy continues to struggle.

Some pension executives are thinking beyond the pure derisk/re-risk conundrum. The Santander (U.K.) Group Pension Scheme, Buckinghamshire, England, has just under £10 billion (US$15.4 billion) in assets and £26 billion worth of pension promises. Despite the fact that the plan sponsor has agreed to contribute £1.5 billion over the next 10 years, “we need to find £15 billion of investment gains somewhere,” said Antony Barker, Manchester, England-based director of pensions for Santander U.K. PLC. “A lot of hedging and generating a "gilts-plus-a-little' return isn't going to fill that gap.”

The fund is about 60% hedged on interest rates and inflation, on a derivatives and physical basis. That allows the return-seeking assets “to chase down that true funding gap. Ultimately we will do more hedging over the next 10 years ... but the question is do we do it now?”

Mr. Barker is targeting a surplus position and 90% hedging on interest rates, inflation and longevity by 2025.

“It is true to say that we have stopped doing derivative- and gilt-based hedging, but we are finding our matching plus-type assets elsewhere.”

He is doing that by building on the real estate portfolio, targeting inflation-linked returns. “We are looking for real assets to hedge our longer-term inflation risk — there aren't enough long-dated gilts to cover our cash flows and (over-the-counter) derivatives engender other risks,” Mr. Barker said.

Statistics show the need to think differently and take action is very real.

Wilshire Consulting showed the aggregate funding ratio of U.S. corporate pension funds fell to 77.8% as of Dec. 31, 2014, a drop of 12 percentage points from a year earlier. In a news release, Wilshire Consulting — a business unit of Wilshire Associates, Santa Monica, Calif. — blamed the drop on new U.S. mortality assumptions and falling corporate bond yields.

Excluding the mortality assumption update, the funded ratio would have been about 82.7%, said Wilshire Consulting.

The story is similar in the U.K. The 350 largest U.K. corporate pension funds had a funding ratio of 85% as of Dec. 31, down from 91% a year earlier, according to consultant Mercer LLC, London.

January was even worse, with bond yields continuing to plummet following the European Central Bank's quantitative easing announcement pushing the relationship between assets and liabilities to a breaking point. Pension deficits hit a record for FTSE 350 companies of £133 billion ($204.2 billion) as of Jan. 31, while the funding ratio dropped to 83%, said Mercer.

“Depending on when measured, U.K. real yields have fallen about 1% in six months,” said Alasdair Macdonald, managing director and head of advisory portfolio management U.K. at Towers Watson & Co., Reigate, England. “A 1% fall in yields equals about a 20% rise in liabilities — the average fund is probably one-quarter to one-third hedged to that.”

And still the pressure builds: Uncertainty rules over when the U.S. Federal Reserve may choose to begin raising interest rates. Pundits in the U.K. predict the Bank of England's decision to begin raising interest rates might take longer than anticipated.

In late January, the ECB unveiled its ambitious €60 billion ($68.4 billion) per month bond buying program, which followed a cut in interest rates in the eurozone into negative territory.

In January alone, 14 central banks cut rates. Nine European countries are trading with negative yields on their two-year government bonds, with Swiss debt trading at negative yields out to 10 years.

Some pension funds have reacted by “stalling their derisking plans as their funding ratios have not reached the desired levels,” said Norbert Fullerton, London-based partner at Mercer Investments.

Ciaran Mulligan, global head of manager research at consultant Buck Global Investment Advisors in London, agreed. “There has been a pause in derisking: in some cases there has been a re-risking. There has been a move into more growth-oriented (assets), but that has been done after a consultation and advice. It is an obvious part of the portfolio to be looking at — are you getting rewarded for holding corporate bonds at the moment?”

Re-risking is taking one of two guises: shifting into riskier assets or reducing the hedges on liabilities.

But adding risk to the asset allocation can be challenging, with markets trading near all-time highs, said Michael Moran, managing director and pension strategist, Goldman Sachs Asset Management, New York. Rather, pension funds might allocate to new subasset classes within their equity allocation, such as international small cap, or add smart beta, “reweighing indexes so they are not market-cap weighted” as a better way to maintain equity exposure, he said. Or, they might choose low-volatility equity strategies, adding exposure but with less dispersion, or “derivatives-based strategies that get that equity exposure but take the tails out” of performance distributions.

And getting riskier assets past a pension fund's board might prove difficult. “That is always a tough ask for a pension scheme,” said Towers Watson's Mr. Macdonald.

As for going down the re-risking road, “we would be stressing to clients that the economic expansion is quite old now — equities are quite high, and of all the times you could choose to take risk, is the right time now? The more likely approach to taking more risk is failure to derisk — if you cannot afford to derisk, then you shouldn't. You need to make sure you can pay benefits.

“I think we will see the pace of derisking being slower than it would have been, or than we had hoped it would be, six months ago or so,” he said.

Other options are to wait it out, seek further cash contributions from the plan employer or cut costs associated with investment.

Pension executives also could look at the triggers in their derisking strategies in the U.K. as a way of riding out the current low interest rates, said John Dewey, London-based managing director in BlackRock Inc.'s client solutions team. With demand for U.K. long-dated gilts expected to exceed supply, the potential for yields to rise is limited. Similar pricing is expected for the eurozone.

“For pension funds with trigger levels to hedge interest rate risk, it is typically appropriate to review these and consider lowering target levels to reflect the prevailing environment of low yields,” Mr. Dewey said.

In the U.S., some companies have used low interest rates to their advantage to sell debt to finance their pension contributions.

With the PBGC premium increasing, companies that borrow to pay contributions “can get an immediate return” by the amount of their PBGC premium at a very low borrowing cost, said Byron Beebe, Cleveland-based U.S. retirement market leader at Aon Hewitt.

Motorola Solutions sold debt to finance contributions last year, said Mr. Beebe, who sees a potential for more companies to do so.

Any pension fund that does consider re-risking or allocating away from the low yields should keep protection in mind.

Gary Veerman, managing director and member of BlackRock's U.S. client solutions group in New York, said the updated mortality tables prompt the question of whether pension funds should be taking re-risking action. “Before the changes, the majority of clients (believed) that derisking was a one-way street: lowering funded status volatility typically by moving money from equities and into fixed income,” he said.

BlackRock executives are talking to clients about the pros and cons of re-risking, with some deciding to go ahead. A key point is that “you can increase equity allocations by decreasing fixed-income allocations, but this doesn't necessarily require hedging less interest rate risk in your liabilities,” Mr. Veerman said.

Officials at a number of pension funds contacted by Pensions & Investments — such as the fund at General Electric Co. — said they have not deviated from their derisking strategies.

A source at a large U.K. corporate pension fund said his fund is already “significantly derisked from an interest rate and inflation perspective.” He added, however, that he knows of pension executives at other funds who have looked at the relatively low market volatility, which affects options pricing. “Therefore, given (the) decent equity run, people are looking at equity options strategies to reduce or reshape the downside risk of their equity exposures,” he said.

GSAM's Mr. Moran said some believe they need even more protection. “They feel they have as much interest-rate risk in the portfolio as they are going to tolerate,” Mr. Moran said.

“So even in this low-interest-rate environment, we've seen some plans looking to add to long-duration fixed income, really some more risk management exercise” and to continue a derisking glidepath by seeking to better match assets to liabilities.