LDI, bigger contributions likely for corporate DB plans

Corporate defined benefit plan sponsors likely will step up allocations to liability-driven investing and raise pension contributions in coming months, according to pension strategists.

Corporate balance sheet derisking and rising variable-rate premiums of the Pension Benefit Guaranty Corp. are key drivers of the moves.

“We do anticipate that more plans will add to their LDI portfolios over time as funded levels move higher, whether that (will) be due to higher interest rates or ... larger incremental contributions,” said Michael A. Moran, pension strategist, Goldman Sachs Asset Management Inc., New York. “When the 10-year (Treasury note) is at 1.65%, it may seem a little surprising that some plans are concerned about (LDI). But maybe this is a 1% world.”

“We are having more conversations” with clients about making LDI moves, said Mr. Moran, who declined to name any.

LDI or other long-duration bond strategies have performed well for pension funds, said Michael A. Archer, Phila- delphia-based senior consulting actuary, Willis Towers Watson PLC.

The Barclays Capital U.S. Long Credit index has returned 11.82% so far this year through June 15, Mr. Archer said.

The long credit index has a duration of 13.9 years, compared to the 5.5-year duration of the Barclays Aggregate index, which covers the broad universe of bonds, Mr. Archer said. Pension funds typically have a 13.9-year duration for their liabilities, Mr. Archer added.

With the long-duration performance this year, Mr. Archer said pension funds with 40% exposure to long fixed income already have a “5% (return) in the bank, and they've gotten a little bit of return from equity. So (almost) halfway through the year, they are doing fine” in their attempt to meet their assumed rate of return, Mr. Archer said.

Pension funds with 75% equity exposure “are probably behind (in their return expectation) at this point in the year. It's still awfully early,” he said.

This year through June 22 on a total return basis, the S&P 500 was up 3.14%, while the MSCI Europe Australasia Far East index was down 0.95%.

For pension funds, the greater the exposure to long fixed income, “the better off they are” in the current market environment, Mr. Archer said.

In addition to their investment returns, corporate plans sponsors “are at a turning point” in raising contributions after three consecutive years of decline, despite continuing federal pension funding relief, Mr. Moran said.

Even though pension contribution funding relief was extended by the Bipartisan Budget Act of 2015 through at least 2020, and many corporate plans have little to no mandatory contribution requirement, “we are seeing ... more and more (corporations) saying ... the economics to making a contribution today makes lot more sense,” Mr. Moran said.

Among S&P 500 companies, total contributions for their plans could rise to an estimated $35 billion to $50 billion in 2016, up from $30 billion in 2015, which was the lowest total contribution since $29 billion in 2008. For all corporations with defined benefit plans, Mr. Moran estimates contributions could rise to between $70 billion and $100 billion in 2016, up from about $60 billion last year.

Rising PBGC variable-rate premiums are a big part of what is driving the move to higher contributions, Messrs. Moran and Archer said. The rate — 3%, or $30, of every $1,000 of underfunding in 2016 — is scheduled to rise to 4.1% in 2019, more than four times the 0.9% rate in 2013, Mr. Moran said.

As a result, the rising PBGC rate trumps pension funding relief in corporate decision-making on contributions, they said.

But the PBGC caps the variable-rate premium at $500 per participant, Mr. Archer said.

“Companies above the cap may be less likely to fund (contributions) and more likely to try to reduce the number of people in the plan,” Mr. Archer said. Such a participant reduction also would save plan sponsors on the rising PBGC fixed-rate premium. At $64 per participant in 2016, it is scheduled to rise to $80 in 2019, up 128% from $35 in 2012.

“We are starting to have more conversations (with plan sponsors),” Mr. Moran said. “One of the strategies we have talked with (them) about is (in a) low-interest-rate environment that's really hurting DB plans, what's the way to make low interest rates work for you. As a sponsor you, take advantage of the low rates by issuing debt ... and then contributing” the proceeds to the pension funds.

Messrs. Moran and Archer see more companies issuing debt to finance pension contributions, as General Motors Co. did earlier this year with a $2 billion debt offering, the proceeds of which were contributed to its pension plans.

Mr. Moran said he has been talking with clients considering such a debt strategy, while Mr. Archer said he knows of other companies that have sold debt to finance pension contributions. Neither strategist would identify any company.

Corporate sponsors feel like they are back where they started in trying to restore their pension plan funding levels before the financial crisis, Mr. Moran said. Corporate executives have a sense of what he calls “pension fatigue.”

“There is a sense of frustration in many (corporations) that they've done a good job from a management perspective, but it's not showing up in results,” Mr. Moran said.

Since the financial crisis “accumulated financial returns have been quite strong,” Mr. Moran said. “Equity and fixed-income markets have done very well post-2008” on a cumulative basis.

“Many plans have comfortably exceeded the long-term expected return assumption they had in place” from 2009 through 2015, Mr. Moran said in a follow-up e-mail.

In that same time frame, some corporations “have put a lot of money into their plans,” Mr. Moran added.

“It's just a frustrating time for many corporate DB plans,” Mr. Moran said. “They are looking at every strategy, whether it be asset allocation related ... liability related, (some) sort of risk transfer, different contribution strategies. In this environment, everything is fair game. They are looking at all the different tools in the toolbox” to improve funded level.

The aggregate funding level of U.S. defined benefit plans among S&P 500 companies has declined steadily from 83% at the end of 2014 to 82% at the end of 2015 to 79% as of May 31, falling to “exactly where it was at the height of financial crisis” in 2008, Mr. Moran said. In 2007, it was 108%, the highest since he began his corporate pension plan analysis in 2001.

The Willis Towers Watson index tracking the hypothetical performance of a pension fund invested 60% equity and 40% fixed income shows a 69.4% funding level as of May 31, down 5 percentage points from the beginning of the year.

The low-interest rate/low-investment return environment has undermined plan sponsors' strategies to meet assumed rates of investment return and stabilize or raise funding levels, Mr. Moran said.

In 2015, pension fund asset returns generally ranged from an average -3% to 3% among S&P 500 companies, Mr. Moran said.

“2015 was the first year since 2008 that the average return” for the 100 largest U.S. defined benefit programs among U.S. publicly traded companies “was less than 5%,” Mr. Archer said. In fact, it was an average -0.3%.

Many companies cannot invest their way out of deeper underfunding even if their pension fund investments meet their assumed rate of return, Mr. Moran said.

Four out of 10 industrial sectors had aggregate annual pension service and interest costs that exceeded their return assumptions last year. In the energy sector, for example, in 2015 the costs were 10.9% of U.S. plan assets, while the assumed return was 7.2%, Mr. Moran said.

“What's really caused the funded ratio not to improve despite quite a bit of contributions is a continuing fall in interest rates,” Mr. Archer said.

The discount rate used by S&P 500 plans fell as of May 31 to an estimated 3.9%, the lowest at least since 2001, and down from 4.3% in 2015. In 2008, it was 6.2%.

The average target allocation to fixed income rose to 43% at the end of 2015 for the 50 largest U.S. plans among the S&P 500 companies, the highest since the start of Mr. Moran's analysis. Equities in turn fell to 37%, their lowest target allocation. Real estate held steady around 5%, while other alternatives and other investments rose to 15%, their highest level ever. n