Despite having steadily boosted their funding levels over the past year, US pension funds run the risk of losing their improved status if they don’t hedge their liabilities, according to a report from investment firm Cambridge Associates. 

Although the “once-yawning gap” between assets and liabilities has been reduced, or in some cases closed, over the past few months, the report warns that improved funding levels bring new challenges, particularly concerning the ratio of the market value of assets to the present value of liabilities.

According to consulting firm Milliman, the funded status of the 100 largest defined benefit pension plans sponsored by US public companies rose to 86% in 2017 from 81.1% in 2016, while their sponsors contributed $62 billion.

The gains, which the report says amounts to billions of dollars, could be squandered unless plan sponsors protect them with strategic adjustments to their liability-hedging portfolio, which is designed to reduce the volatility of a plan’s assets relative to its liabilities as a result of changes in the discount rate, which is used to calculate the present value of employer pension obligations.

“Plan sponsors need to find a new balance between generating returns to close the asset-liability gap and protecting any incremental improvements in funded status,” Alex Pekker, senior investment director at Cambridge Associates, and co-author report, said in a release.

“Until recently, closing that gap has rightly been the primary focus, and now since the funded status has improved for most plans, the balance should be shifting to the liability-hedging portfolio.” 

Pekker says that although striving for fully funded status is a laudable goal, plan sponsors should consider revisiting their investment strategy to develop a more nuanced approach to liability management  to protect their gains. Specifically, he says plans need be aware of three new risks they face:

• Curve Risk: Well-funded plans can afford to hedge not only the overall interest rate risk of the liability, but also its sensitivity to the “full maturity spectrum” of interest rates. The report says this is important because short-term rates often move differently than long-term rates, and therefore it is possible to lessen these differing curve exposures through customized portfolio construction and the use of derivatives.

• Credit Spread Risk: Because liabilities are valued using near top-rated corporate bond yields that incorporate the difference between the yield of a corporate bond, and the yield of a comparable Treasury, plan sponsors can invest in credit to hedge the difference in yields, also known as the credit spread. Because credit is correlated to equities, the allocation to credit should increase as the size of the growth portfolio decreases, and the liability-hedging portfolio increases.

“Even a fully funded plan has an incentive to outperform the liabilities to offset ongoing administrative costs and any future mortality improvements,” said Pekker.

• Operational Complexity Risk: Plan sponsors tend to use more managers and more complex instruments, such as Treasury futures and interest rate swaps, when hedging curve and credit spread risks. According to Cambridge Associates, this introduces more complexity, which means plan sponsors should be aware of the additional operational and reporting burdens, and ensure that any associated risks are managed appropriately.

“Articulating a coherent liability framework and revisiting it frequently will serve plans well in maintaining an effective liability hedge exposure,” said the report.

Tags: Cambridge Associates, Funded Status, Pension