Equities a sinking allocation for corporate DB plans

The heyday of equities in corporate defined benefit plans is over.

Corporate pension plan allocations to equity have declined to a new low, according to two reports by Standard & Poor's and PricewaterhouseCoopers.

And the fixed-income allocation has risen to a new high.

At the end of 2014, the equity allocation stood at 44.45%, the lowest since S&P began tracking it in 1999, with the exception of 2008 when, in the midst of the financial crisis, it was slightly lower at 43.71%.

Fixed-income allocation was 43.88%, a record high in the S&P reporting.

In another study, a PwC report last week on companies in the Fortune 100, the median defined benefit plan equity allocation was 38% at the end of 2014, down 26 percentage points from a 64% median allocation in 2007. During the same period, the fixed-income allocation rose to 42% from 29%, the PwC data show.

“I do think it is fair to say at least in the short term I don't see any expected reversal” in the trend toward lowering the equity allocation by corporate plans, said Ken Stoler, Los Angeles-based partner, PricewaterhouseCoopers LLP.

“From the companies I work with I haven't heard any starting to think in that direction” of raising their equity allocation, Mr. Stoler said. “If anything they are looking to move further in that direction of (derisking) rather than reverse course and start pumping the equity portion of their portfolios back up.”

Jay Love, Atlanta-based partner and senior consultant, Mercer Investment Consulting, said of the current equity allocation trend: “I don't feel like that's at a low point and likely to rise up.”

In moving away from equities as the market enjoyed positive returns the last six calendar years, including double-digit returns for five of them, corporate pension executives lost out on some upside, Messrs. Love and Stoler said.

“That is certainly part of the tradeoff (of) moving ... into fixed income while the equity market is going strong,” Mr. Stoler said. “They are missing out. That is part of the business decision companies are making. They understand there is a potential for greater return ... of being more heavily in equities.”

But the effects of the financial market collapse still concern the executives, Messrs. Love and Stoler said.

The crisis reduced the S&P 500 companies' aggregate funded levels to the 78% in 2008 from 104% in 2007, according to the S&P analysis.

Corporate plan executives “are comforted that we are less subject to that potential downside” of the equity market,” Mr. Stoler said. Now they “are looking at the assets and liability more in tandem rather than ... managing the assets separately from this big liability.”

Not all of the reallocation out of equity has flowed to fixed income, Mr. Love said. Real estate and hedge funds strategies also have captured some of the reallocation to diversify growth assets.

“I don't think those plans feel like they are missing out on anything. Real estate has done particularly well,” for example, Mr. Love said.

For many plans de-emphasizing equities, risk management is a first priority and “improving their funded status through investment risk is a second priority,” Mr. Love said.

Corporate pension plan aggregate underfunding reached its second-highest level ever in 2014, despite the last three years of double-digit equity returns, the S&P report showed.

A continuing low-interest-rate environment combined with increased longevity risk deepened underfunding, despite favorable equity markets, noted the report, issued in June, “S&P 500 Corporate Pensions and Other Post-Employment Benefits (OPEB): Heading into the Sunset, a Half-Trillion Dollars Short,” by Howard Silverblatt, senior index analyst.

At the end of 2014, combined underfunding of the S&P 500 companies with defined benefit plans rose to $388.96 billion, up 73% from $224.46 billion at the end of 2013. The funded ratio fell in 2014 to 81.22%, down from 87.85% at the end of 2013. In 2007, the S&P 500 corporate plans had aggregate overfunding of $63.3 billion.

The number of corporate DB plans is also shrinking.

In all, 329 S&P 500 companies had defined benefit plans in 2014, down from 336 companies in 2013.

Mercer puts the funded level at 83.2% at the end of May, Mr. Love said.

The PwC report, released July 22, placed the funded level at 83% at year-end 2014.

Even though aggregate S&P 500 pension plan assets rose in 2014 to $1.682 trillion, up 3.6% from $1.622 trillion at the end of 2013, pension liabilities rose at a faster rate to $2.070 trillion, up 12.1% from $1.8547 trillion.

“Funding has decreased across the board,” with more companies becoming underfunded, the report said.

At the end of 2014, 24 companies had fully funded plans, down 53% from 51 companies at year-end 2013. In the same period, 50 companies were funded at 90% to 100% levels, down 40% from 84 companies in the earlier period.

The current interest rate environment has challenged efforts of corporate executives to improve plan funded levels, despite derisking and a volatility-reduction strategy of asset-liability matching as well as billions of dollars in contributions over the last six years.

Aggregate funded levels fell in 2014 and are near the lows of the financial crisis, including 81.7% in 2009.

“I think that on a marked-to-market basis that those funded ratios are perhaps a little temporarily low ... because interest rates are at a cyclical low,” Mr. Love said.

Corporate plan sponsors have steadily lowered their assumed rate of return on pension assets every year without exception since 1999, the S&P report shows. The median rate fell to 7% in 2014 from 9.17% in 2000.

In the PwC report the median assumed return was 7.3% as of the end of 2014, down from 8.3% in 2007, the farthest back the data goes.

Plan sponsors steadily lowered their discount rate as well to 3.92% in 2014 from 7.44% in 1999.

In the PwC report the median discount rate fell to 4% in 2014, down from 6.25% in 2007.

Both declining rates have contributed to lower funded levels, Messrs. Love and Stoler said.

Mr. Stoler said the primary drivers damaging funded levels and raising pension liabilities have been the decline in interest rates and the implementation of new actuarial mortality rates that increased longevity, adding to liabilities.

“These aren't things a company can control,” Mr. Stoler said.

At 48 companies that disclosed the impact, the new mortality assumptions increased benefit obligations a median 5% but ranging from less than 1% to 15%, according to the PwC report.

In terms of the outlook for asset allocation, Mr. Love said, “It's going to depend ... what happens with the markets. A lot of plans would like to reduce their overall risk (and) increase their fixed income,” decreasing equities more. But “they feel like interest rates are at cyclical lows and would rather wait for rates to rise before they make those kinds of changes.”

Such change would be gradual, not triggered by an interest rate rising to a particular level, Mr. Love said.

Rising interest rates and improved funded levels are likely to encourage plans to take liabilities off corporate financial statements and transfer them to insurance companies through annuitization, Mr. Love said.

“Companies are looking for approaches to derisk their plans,” Mr. Stoler said. One approach “is changing investment strategy. Another is to settle plans by transferring obligations to an insurance company.”