Lack of Hedging Threatens Pensions Recent Improvements

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.

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“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

Corporate pension contributions totaled $62 billion in 2017, with seven employers contributing more than $2 billion to their plans, and another 10 adding at least $1 billion to their pensions’ coffers, according to consulting firm Milliman.

The annual study of the 100 largest defined benefit pension plans sponsored by US public companies found that the contributions pushed last year’s total assets to a record $1.55 trillion, and represent a 45% increase from the $42.6 billion contributed in 2016.

“There were incentives to increase contributions in 2017,” Zorast Wadia, co-author of Milliman’s Pension Funding Study, said in a release. “Additional contributions can both reduce the PBGC premiums paid by these plans, and allow them to leverage higher tax deductions in light of tax reform enacted at the end of 2017. It’s a trend that’s likely to flourish in 2018.”

Rising global equity markets contributed to strong investment returns in 2017, with the average plan earning approximately 12.7%, according to Milliman. Overall, investment returns added $175 billion to plan assets, far more than the $92 billion that was expected based on the companies’ long-term investment return assumptions.

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The funded ratio for the Milliman 100 plans rose from 81.1% in 2016 to 86.0% in 2017, an increase due largely to strong investment returns coupled with a modest decline in life expectancy assumptions, and the higher level of plan contributions as noted above. Funding ratios for plans ranged from a low of 62.4% for American Airlines to a high of 155.0% for NextEra Energy, Inc.

An additional factor contributing to the improvement in funded ratios was a modest decline in life expectancy assumptions due to participants and pensioners not living quite as long as previously predicted by the Society of Actuaries. This reduced the actuarial present value of the pension benefits, referred to as the projected benefit obligation (PBO).

Despite the strong equity markets and higher short-term interest rates, the discount rate declined during 2017 to 3.60%, down from the 3.97% rate a year earlier. As a result, the PBO of the Milliman 100 plans increased to an all-time high of $1.8 trillion (an $82 billion increase since the end of 2016). The report also points out that the $62 billion in contributions still left a $20 billion hole to be covered, which investment returns helped to overcome.

During 2017, pension risk transfers programs matured, with an overall acceptance by the participants and the financial markets, according to Milliman. It said it is unaware of any significant litigation by participant plaintiffs claiming they were harmed or otherwise disadvantaged by a pension risk transfer.

The study also said now “measurable reductions” in future premiums to be collected by the Pension Benefit Guaranty Corporation (PBGC), which it said experienced funded status gains in the federal fiscal year ending September 30, 2017. The PBGC recorded a 91% funded ratio for the plans that terminated and were sent to PBGC as the receiving custodian. In 2017, PBGC total premium income exceeded pension claims by more than $1 billion for the first time.

Tags: Corporate Pension, life expectancy, Milliman, Pension