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Asset AllocationMay 9, 2023

Corporate Pension Funds Are in Good Shape, So What’s the Worry?

Goldman’s Michael Moran warns against complacency and issues some warnings.

Corporate defined benefit pension funds are in fine fettle: Goldman Sachs Asset Management says their funded status topped 100% last year, even as their investments lost 18%. Now the question is: What’s next for the funds?

In a commentary, Michael Moran, senior pension strategist at the investment firm’s asset management arm, warned against getting too comfortable. “Despite a strong improvement in funding ratios, now is not the time for plan sponsors to be complacent, as they must walk a tightrope of managing competing forces and priorities,” he told a Goldman interviewer in a company publication.

One possible problem, he said, is that many plan sponsors are escalating their 2023 estimated return on assets, or EROA, to potentially unsustainable levels, driven by the current rise in U.S. Treasury yields, among other factors. While that may help boost their parent companies’ net income (usually by reducing corporate expenses on the profit-and-loss sheet), it also risks “a greater chance of future shortfalls.” The higher they rise, the more painful the fall, if one happens.

Corporate plans now are more concentrated on bonds than stocks. Goldman statistics show that their average fixed-income allocation is 50%, with 29% in equities. That’s a shift from 10 years ago: 39% bonds, 42% stocks.

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That changed allocation has helped funded status, as bonds suffered less in last year’s market wipeout than did stocks. But if the higher 2023 EROAs result from moving more into stocks, Moran warned that could entail both bigger losses ahead and more volatility. Some plans still suffer from a “mismatch” of assets and liabilities, he noted, meaning that not all have sterling funded statuses.

Meanwhile, the good news is much-welcomed by plans. The discount rate—the metric used to value the current cost of future obligations—has pushed up, thanks to rising interest rates, seen partly in widening credit spreads between corporate bonds and Treasurys. That, in turn, has led to a decrease in liabilities, a boon to plan sponsors.

The discount rate increased about 2.45 percentage points in 2022, “with many plans consequently seeing their liabilities fall by about 25%,” Moran pointed out.That more than made up for the 18% investment drop. The estimated discount rate last year was 5.4%. Higher returns today imply less need for contributions to plans in the future.

The systemwide jump in funded status to more than 100% marked the first time it reached that level since 2007, right before the global financial crisis.

Moran counseled that, “It is important that plan sponsors reviewing the various trade-offs manage them appropriately, taking into account their obligations as plan fiduciaries.”

British Regulators Issue LDI Guidance So ‘Necessary Lessons Are Learned’

The Pensions Regulator and the Financial Conduct Authority aim to prepare LDI investors for future volatility.

By Michael Katz

The UK’s Financial Conduct Authority and The Pensions Regulator have published guidance for asset managers and pension funds intended to help funds manage risk when using leveraged liability-driven investments.

The guidance comes in response to the September 2022 bond market meltdown, when U.K. financial assets saw severe re-pricing, particularly of long-dated government debt. The spike in yields triggered collateral calls and forced gilt sales that led to market dysfunction for firms with LDI strategies.

The FCA has since been working with other regulators, both in the U.K. and abroad, and has engaged directly with firms involved in managing LDI portfolios to develop and maintain increased resilience to minimize any future volatility.

“We have been closely monitoring asset managers using LDI strategies as they make improvements and the sector is now much more resilient to potential risks, but there is more to be done,” Sarah Pritchard, the FCA’s executive director of markets, said in a release.

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The FCA’s guidance, which follows recommendations from the Bank of England’s Financial Policy Committee, focuses on risk management and operational arrangements for LDI managers. It sets out what the FCA expects in terms of risk management, stress testing, and client communications, “so that the necessary lessons are learned from last September’s extreme events,” Pritchard said.

TPR is reminding trustees that they are responsible for how the assets in their plan are invested, and its guidance stresses the importance of having the right governance and controls in place to reduce risks, and to react quickly to extreme events.

According to TPR, it expects trustees to only invest in leveraged LDI arrangements that have an appropriately sized buffer in place. This must include an operational buffer specific to the LDI arrangement to manage day-to-day changes, in addition to the 250 basis points minimum to provide resilience in times of market stress.

The regulator is also urging trustees to make sure there are processes in place to monitor the resilience of LDI arrangements, taking into account TPR guidance on monitoring pension plan investments.

“The unprecedented market volatility seen last September clearly demonstrated there is the need for stronger buffers, more stringent governance and operational processes and more oversight by trustees,” Louise Davey, TPR’s interim director of regulatory policy, analysis and advice, said in a release. “Trustees must understand the risks they carry in their investment strategy, and only use leveraged LDI if appropriate. Our guidance provides practical steps to ensure they achieve this vital balance, and we expect trustees to use it.”