Liabilities mostly offset high returns around globe

Corporate pension funds in the world's largest retirement markets posted stellar gains in 2019 on the back of aggressive monetary policy stimulus, but many ended the year with little to show in terms of improved funding levels.

The U.S. Federal Reserve Board's abrupt shift to monetary easing from tightening as 2019 began ignited stock and bond rallies around the globe. For the year, the S&P 500 surged 31.5%, the MSCI All Country World index climbed 26.6% and the MSCI Emerging Markets index gained 18.4%. A spate of central bank rate cuts pushed bond prices higher as well, with the Bloomberg Barclays U.S. Long Credit Total Return index rising 23.4% and the U.S. Aggregate adding 8.7%.

That tailwind produced a banner year for corporate pension funds in the world's seven largest retirement markets — the U.S., U.K., Japan, Australia, Canada, the Netherlands and Switzerland — with gains ranging from 18.2% in the Netherlands to 6.8% in Japan, according to investment consultants' estimates.

For 2018, which ended with a dramatic global sell-off of stocks in reaction to the Fed's rate hikes, not one of those pension fund markets reported a positive average return.

But last year's recovery proved a double-edged sword for a number of big pension markets, as falling interest rates boosted long-term pension liabilities as well.

For U.S. corporate pension funds, 2019 was a "horse race between asset and liability growth," said Steven J. Foresti, chief investment officer at Santa Monica, Calif.-based investment consultant Wilshire Consulting.

U.S. plans posted average investment returns of 16.8% for the year, as stocks and bonds alike delivered gains of roughly 20%, Mr. Foresti said.

An environment like that — which spawned the strongest annual gain since a 19% surge in 2003 — would normally produce a considerable improvement in funding levels. But instead, Wilshire's tally for the aggregate funding ratio of U.S. corporate pensions only edged up to 88.2% at the close of 2019 from 87.5% the year before, he said.

"Assets were working hard for investors" but a roughly 1 percentage-point fall for the year to 2.4% in the U.S. AA corporate bond yield used to discount long-term pension obligations led to an almost commensurate increase in liabilities, Mr. Foresti said.

On the positive side, funding levels of close to 90% "aren't too shabby," leaving corporate funds in a decent position to continue — along their planned "glidepaths" — taking risk off the table as and when funding levels push higher, he said.

But with little change in funding levels over the past year, current exposure to equities — in the neighborhood of 40% or more — should remain in place, even though Wilshire's outlook for equity returns over the coming 10 years stands now at around 6%, well below historic averages, Mr. Foresti said.

A similar story unfolded in Canada's corporate pension market in 2019. A pension plan with a traditional 60/40 mix — composed of 20% in Canadian equities, 40% in global equities and 40% in "Canadian universe" bonds, rebalanced monthly — would have enjoyed a 15.7% return, but the lowest long-term bonds yields in more than 60 years offset much of those gains by boosting pension liabilities as well, said Andrew Kitchen, a Toronto-based managing director, institutional Canada, for Russell Investments Canada.

For the year, the solvency ratio of Canadian defined benefit pension plans only improved to 94% from 92% the year before, he said.

All-time lows for Canadian bond yields in 2019 led to all-time highs for corporate defined benefit pension obligations, with a 15% jump in liabilities over the past year alone, said Andrew Whale, a Toronto-based principal in Mercer Canada's financial strategy group in a review of corporate DB plans over the past year.

The median solvency ratio for Mercer's corporate pension clients in Canada rose to 98% from 93%. By Mercer's estimates, a typical balanced pension fund in 2019 would have delivered a 17.4% investment return.

Consultants at both Russell and Mercer said the boost in pension liabilities on the balance sheets of companies with DB plans has left corporate executives focusing more on options such as pension buyouts or pension risk transfers. The cost premium of settling DB obligations by purchasing an annuity over keeping those DB obligations on the balance sheet have shrunk and "we have seen their appetite for annuities increase tremendously," said Mercer's Mr. Whale.

Russell's Mr. Kitchen said risk transfers won't be the appropriate solution for all plan sponsors, with those seeking other ways to manage DB asset volatility now boosting allocations to alternative assets and private market exposures.

Corporate pension funds in the U.K. likewise saw only small improvements in funding levels last year — to 97% on average from 95% the year before — despite a strong 13.5% investment gain, said Charles Cowling, a London-based partner with Mercer.

While fears last year about the potential impact of Brexit on U.K. interest rates and inflation didn't materialize, Mr. Cowling said, "how much of our investments we need to hedge to our liabilities" remained a top focus.

There was "a lot of talk about increasing" hedging, and a record pension buyout tally of £40 billion ($52.6 billion) in 2019 — up sharply from the record of £25 billion set the year before — is one obvious expression of that interest, he said.

At the same time, allocations to bonds or other asset segments useful in hedging liabilities continued to rise steadily to 60% to 70% now, more than doubling over the past decade, Mr. Cowling said.

For the coming year, a government review of how inflation is measured and consultations by the U.K.'s Pensions Regulator that could introduce more long-term pension funding targets bear watching, he said.

Corporate pension funds in the Netherlands experienced a similar tug of war to those experienced in othe markets, with impressive investment gains for the year largely offset by a sharp increase in liabilities, said Edward Krijgsman, a principal with Mercer.

For the year, the roughly 40% of pension portfolio assets hedged with long-duration bonds performed well, as did growth asset exposures like equities and high-yield bonds, producing average returns of 18.2%, Mr. Krijgsman said.

But the average funding level for corporate pension funds in the Netherlands only edged up to 104% from 103% the year before, reflecting a 14% to 16% rise in liabilities as the 30-year euro swap rate used to discount future pension obligations dropped to 0.62% from 1.38% in 2019, Mr. Krijgsman said.

Otherwise, he said most corporate pension funds refrained from making significant allocation changes in 2019 ahead of ongoing government reviews of the country's pension system, including one that could move the market in the direction of a hybrid defined contribution-defined benefit structure. Market players are hopeful those questions can be settled during the coming year, but it's possible deliberations could drag on through 2021, the Mercer veteran said.

In Australia's superannuation industry — with individual defined contribution-like member accounts for retirement assets that are managed like a defined benefit plan — the link between falling interest rates and more onerous pension obligations is severed. Even so, low rates continue to present other challenges for the system, said Kirby Rappell, executive director of SuperRatings Pty. Ltd., a Sydney-based research and consulting firm.

The country's superannuation funds enjoyed a 14.7% gain in 2019, the strongest performance since 2013's returns of 14.9% and the third-best calendar year result since the retirement system was launched in its current form roughly 30 years ago, Mr. Rappell said.

For Australia, the question is whether the declines in interest rates at home and abroad are pulling future returns forward, as 2019 proved to be yet another year when predictions that torrid investment gains will give way to more modest returns proved premature, he said.

Returns for the latest 10 years have been close to 5.5% on an inflation-adjusted basis, well over the typical objective of 3%, he said. The "main conundrum here is that super fund members have become used to very strong returns," saddling fund administrators with the task of preparing them for a decade to come that will likely be more tepid, he said.

For pre-retirees and members in retirement who are more dependent on defensive asset classes like fixed income and cash, it's actually a pretty challenging environment now, Mr. Rappell said. The current backdrop effectively makes "haves" of members who don't need to draw down their retirement savings anytime soon and "have-nots" of those closer to or in retirement, he said.

Japan's corporate pension funds — with investment return targets of around 2% to 3% and relatively low equity allocations of less than 25% — posted an average gain of 6.8% in 2019, rebounding from a decline of 3.6% the year before, said Kita Konosuke, Tokyo-based director, consulting, at Russell Investments.

Funding levels improved to an estimated 102% of pension benefit obligations, from 98% at the end of 2018, he said.

During the year, pension fund managers strove to lessen portfolio volatility, favoring allocations to private debt and global real estate. However, a previous magnet for Japanese pension money — insurance-linked securities, such as catastrophe bonds — lost some of their attraction as the costs of some natural disasters have exceeded expectations in recent years, he said.

With rock-bottom yields on Japanese government bonds and high valuations for equities, especially in the U.S., few pension trustees will be looking to add risk this year, said Mr. Kita. More than 25% of Russell's corporate pension clients took steps to put downside protection in place, and a few more look set to do so in the year to come, he said.

Nico Fiore, a Zurich-based consultant with Willis Towers Watson, said investment returns for Swiss pension funds in 2019 averaged 11%, and — significantly — without a corresponding rise in liabilities. He estimated the average funding level for corporate funds in Switzerland jumped to 118% from 108%.

In Switzerland, trustees overseeing corporate pension funds set the discount rate used to calculate future pension obligations, Mr. Fiore noted. Any adjustments to discount rates occur gradually, resulting in less volatile increases in pension obligations, he said.

The average discount rate for Swiss corporate pension funds, which was 2.1% at the end of 2018, will likely be about 2% at year-end, but that remains a rough estimate until more data become available.