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The P&I 1000: Fixed income

Fixed income still prized in asset mix of corporate funds

Allocations increase 10%; plans with LDI mindset taking a special interest

Nathan Wong believes ever-rising PBGC premiums will give DB sponsors incentive to keep funding high.

Buoyed by large contributions as a result of tax reform, U.S. corporate defined benefit plans continued the trend in 2018 of devoting a greater share of their portfolios to fixed income.

As funding improved and glidepath targets were hit, plans particularly increased allocations to liability-driven investing, Pension & Investments' latest survey of the 1,000 largest U.S. retirement plan sponsors shows.

Overall, among U.S. defined benefit plans of the largest 200 plan sponsors, domestic fixed-income assets totaled $967.4 billion as of Sept. 30, a 10% increase from a year earlier. The increase stands in stark contrast to the Bloomberg Barclays U.S. Aggregate bond index return for the same period at -1.22%.

Among the DB plans in the top 200, LDI strategies accounted for $94.1 billion in assets as of Sept. 30, up from $78.9 billion reported a year earlier.

Among corporate DB plans in the top 200, there was a further shift to domestic fixed income as a whole, not just in LDI strategies, with an average asset allocation to domestic fixed income at 43.4% as of Sept. 30, above the 38.8% average allocation a year ago.

United Parcel Service Inc. reported the highest asset total in LDI strategies at $15.6 billion as of Sept. 30, about double the $7.9 billion reported as of Sept. 30, 2017, and comprising 37.8% of its $41.25 billion in U.S. DB plan assets.

The increase in LDI assets for the Atlanta-based shipping company came on the heels of $7.3 billion in contributions to the U.S. pension plans in 2017. Like similar companies that accelerated contributions to their defined benefit plans in 2017 and 2018, UPS said it had done so to take advantage of the 35% corporate tax rate deduction before the Tax Cut and Jobs Act's lowering of the tax rate to 22% would take effect.

Through those massive contribu- tions, UPS improved the funding ratio of its U.S. pension plans to 91.5% at year-end 2017, compared to 76% a year earlier, according to the company's most recent 10-K filing.

Carter Holcombe, portfolio manager for UPS' group trust, said in a telephone interview that the improved funded status, paired with the impending freeze of UPS' largest defined benefit plan at the end of 2022, motivated the increase in LDI assets.

"The plan's really healthy right now," Mr. Holcombe said. "We're not targeting hibernation immediately on the freeze date. I think we're focused just on making the plan as healthy as possible as it's sunsetting."

Mr. Holcombe said a large portion of the assets from the giant contribution were moved into LDI, adding while the company is "planning on immunizing the plan" on the date it freezes, much of what UPS will do depends on market conditions beyond that date. The plan does not have a specific glidepath, he said.

The UPS Retirement Plan for non-union employees, the plan being frozen, accounts for about half of UPS' total DB plan assets, Mr. Holcombe said. UPS announced in June 2017 that the plan would freeze benefit accruals as of Jan. 1, 2023.

Ranking high with LDI

United Technologies Corp., Farmington, Conn., reported the second-highest amount of LDI strategy assets, with $12.65 billion as of Sept. 30, down 3% from the year before. General Electric Co., Boston, ranked third among plans with LDI strategy assets, reporting $9.2 billion, up 31.4% from the year before. GE also increased the overall domestic fixed-income allocation within its $54.3 billion defined benefit plan to 32.8% from 25.3% the prior year.

Also reporting one of the higher amounts of LDI strategy assets was Honeywell International Inc., Morris Plains, N.J., which implemented an LDI strategy in 2018, giving it $8.9 billion in LDI strategy assets, or 44.2% of the U.S. DB plan's total $20.1 billion in assets.

In the year ended Sept. 30, the company oversaw a significant shifting of its asset allocation, dropping domestic equity and international equity to 35% and 4%, respectively, from 56% and 13% the year before and bringing domestic fixed income to 44% from 13% the year before.

Calls to Honeywell were not returned.

Johnson & Johnson, New Brunswick, N.J., also reported a significant increase in LDI assets, to $3.84 billion as of Sept. 30, almost five times its $772 million a year earlier.

One corporate DB plan investment head, who asked not to be identified, said his plan's improved funded status enabled the plan to move further along in its glidepath for its LDI strategy. It was, however, not a "seismic shift," the investment head said.

"For us," he said, "we follow a simple funded status glidepath and our funded status improved (in the year ended Sept. 30) and being stewards of our investment policy we took risk off in a gradual manner to match that improvement in funded status. Really for us, it's a gradual shift to take risk off the plans."

While his plan's funded status improved significantly, it was not due to accelerated contributions. Rather, strong market returns for the year ended Sept. 30 was the primary driver.

"It just demonstrates the importance of setting an investment policy and following it," the investment head added. "It seems fairly simple but important to execute on the strategy."

John J. Delaney, Philadelphia-based portfolio manager at Willis Towers Watson PLC, said in a telephone interview that the increase in discount rates in the first nine months of 2018 also contributed to the improved funding levels that led plans to move further along their glidepaths, along with strong equity markets and those accelerated contributions.

More contributions likely

Now that the Sept. 15, 2018, deadline to take advantage of the old tax laws has long since passed, U.S. corporations still are likely to accelerate their contributions, said Nathan Wong, San Francisco-based vice president, global manager research at Callan LLC..

"PBGC premiums continue to go up," Mr. Wong said. "I don't think that is going to change."

The Pension Benefit Guaranty Corp.'s variable rates are determined by the funded status of a plan and is now $43 per $1,000 of underfunding compared to $9 per $1,000 of underfunding just five years ago.

Improving the funded status of a plan for that reason is the "biggest thing on (fund executives') minds," Mr. Wong said.

In other areas of domestic fixed income, DB plans in the top 200 reduced their exposure to high yield.

The one outlier was General Electric, which reported it had $4 billion in high yield as of Sept. 30, up from zero the year before.

The creation of the high-yield portfolio stood in stark contrast to a 12% overall decrease in high yield among the defined benefit plans in the top 200 to $71.1 billion as of Sept. 30. That is a decrease from $80.8 billion a year earlier.

Some plans and their managers reduced exposure to high yield because of their views of where corporate credit is heading.

"In terms of our exposure," Willis Towers Watson's Mr. Delaney said, "what we looked at is our valuation case for high yield, the valuation case for loans. We think of that being the corporate-based alternative credit space, and saw in the high-yield space, the level of default that was priced vs. what could happen over the next couple of years."

"What we did was reduce our high-yield exposure from a third of the alternative credit space at the beginning of the year to about 10% at the end of the year," Mr. Delaney said. "It's a pretty significant reduction in terms of our view of corporate credit."

The defined benefit plan that reported the largest drop in high-yield exposure was the California Public Employees' Retirement System, Sacramento, which reported $7.8 billion in high-yield assets as of Sept. 30, just more than half of the $14.8 billion it reported a year earlier.

Others reducing high-yield exposures included:

  • The $99.1 billion plan of the Ohio Public Employees' Retirement System, Columbus, dropping to $2 billion from $2.8 billion in high yield.

  • $15.9 billion Ohio Police & Fire Pension Fund, Columbus, to $1.3 billion from $2.16 billion.
  • The $73.1 billion DB plan of the State of Michigan Retirement Systems, East Lansing, to $487 million from $1.02 billion.

    The $27.7 billion Northrop Grumman Corp., El Segundo, Calif., DB plan, whose high-yield exposure fell to $431 million from $1.5 billion.