Unfunded Liabilities of Largest Pension Plans in U.S. Increase, While Assets Rise

The biggest force affecting the underfunding was interest rates.

The unfunded liabilities of the US’s 19 largest pension plans rose to $189 billion, an increase of $12 billion from last year, according to a new report from Russell Investments. The shortfalls from the 19 pension funds of the nation’s largest publicly-traded corporations in the healthcare, aerospace, automotive, technology, oil and gas, logistics, and chemical sectors, rose due to a fall in the discount rates used to value liabilities.

While these large corporations, which Russell calls the “$20 Billion Club,” saw an increase in liabilities, the long-term liability trend is going lower, the report found. The 2016 total of $902 billion is below the high point of $933 billion reached in 2014. “Unless there is a substantial fall in interest rates this year, 2014 may well prove to be “peak pension,” the point at which defined benefit plan liabilities reached their high,” the report said.

Yet as liabilities rose, the report found that assets continued to grow. Asset growth would allow plan sponsors to address their collective $189 billion pension fund deficit. This would mean that with 2016 total assets less than 5% below 2014’s level, strong investment performance in 2017 could see a new high, the report said.

Pension funds were also negatively affected by mark-to-market accounting which accelerated gains and losses and contributed to higher pension costs in 2016. The fall in the discount rate and other market factors were all realized more quickly as a result of mark-to-market accounting.

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“The total loss recognized by the six corporations who use a mark-to-market approach was $9.9 billion, approximately 4% of year-end liability value. The loss recognized by the 13 corporations who do not mark to market averaged less than 2% of their liability value,” the report said.

According to Bob Collie, chief research strategist, the main reason for the decline in 2016 was a decrease of about 0.25% in the discount rate used to value liabilities. However, this decline was offset by a slight increase in plan sponsor contributions and a slight rise in investment returns.

The biggest force affecting the underfunding was interest rates, specifically the median discount rate used to value liabilities.  His accounted for the actuarial loss of $38.7 billion among the pension plans of the largest corporations.

On the asset size, the report said investment returns “were solid,” with returns ranging from 4.7% to 12% from the 18 corporations that reported returns on a calendar basis. “This was more than enough” to cover the interest cost of $31.9 billion in liability growth, the report said.

Pension contributions were another story. These varied widely among the 19 corporations, with about half making discretionary contributions in 2016 and the rest failing to make them. One reason for the differences in voluntary contributions was due to increases in the PBGC’s variable rate contribution schedule. This change gave pans a few more choices in how they addressed their underfunding situations. These changes, Collie said, meant “sponsors will increasingly choose to make discretionary contributions above the required minimum in order to reduce their funding shortfalls.”  

Looking ahead to 2017, Collie said “while the past few years have shown that interest rates have been the biggest factor driving changes in interest rates (even more than investment returns),  if we enter a rising rate environment, we could see substantial improvement in funded status. If we look, for example, at 2013’s improvement that was mainly caused by the median discount rate used to value liabilities rising from 4.0% to 4.89%. If rates rise in 2016, we’d expect to see a similar effect. The other cause of year-to-year variation is, of course, investment returns. Those are the big two.”

Collie also said contributions are important,” especially when you look at the longer term. Currently, contributions are still fairly low as many corporations continue to take advantage of the flexibility offered by funding relief to defer contributions. But, we expect to see discretionary contributions tick up as a result of PBGC premium increases, and there are signs that’s starting to happen. Overall, the pension fund situation really comes down to interest rates and investment returns,” Collie said.

When Should a Pension Plan Borrow to Fund its Liabilities?

In contrast to Russell’s latest 2016 report, pension plans in 2015 started to borrow money rather than continue with a pension deficit. In a paper written by Russell’s Jim Gannon, changes in the way the Pension Benefit Guaranty Corporation (PBGC) gave underfunded plans more flexibility in how they corrected their shortfalls. This change, which was part of the in the Bipartisan Budget Act of 2015, gave sponsors more options in determining their contribution schedules, including a reduction in  their minimum contributions to correct underfunding. But it also meant they could face higher costs from the PBGC’s variable funding option, which is a high costs for underfunded plans.

In a scenario modeling “amortization of unfunded liabilities,” Gannon used key variables (such as credit rating, interest rates, PBGC premiums) to calculate whether  the “breakeven rate” makes more sense for the corporation to either borrow or continue to fund the plan annually.

By Chuck Epstein

Report: Defined Contribution Funds Significantly Exposed to ESG Risk

ESG investing has gained significant momentum in Great Britain, with £1.4 trillion in assets under management in the wider investment community in 2015, up from £500 billion in 2013.

A new study has found that UK defined contribution funds are significantly exposed to environmental, social and governance (ESG) risks related to human capital, business ethics, product safety, and data privacy and security.

According to the study, which was released from by UK-based Pensions and Lifetime Savings Association (PLSA) and Sustainalytics, an independent ESG and corporate governance research firm, a fully indexed default fund is likely to contain a large number of companies that trail in ESG policy.

“We no longer understand ESG as a niche product designed to enshroud investors in a warm glow of righteousness,” said PLSA’s Luke Hildyard, “but as a critical component of the wisest investment strategies.”

The report said that empirical evidence shows that ESG integration is “positively associated with financial return, and that the downside impacts of many ESG risks, including climate change, are intensifying.” It also said the recent move by HSBC to shift the equity of its default fund into a climate-tilted factor index “could sit at the vanguard of an important new trend among DC plans in the UK.”

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ESG investing has gained significant momentum in Great Britain, with £1.4 trillion in assets under management in the wider investment community in 2015, up from £500 billion in 2013. It also said the number of defined contribution plan members in the UK will increase dramatically over the next 10 years. According to the Pension Policy Institute (PPI), there could be 17 million members enrolled in defined contribution workplace plans in the UK by 2030, up from 11 million today, with an aggregate pension total of up to £914 billion ($1.14 trillion).

A typical default fund offered by defined contribution plans in the UK has a 71% allocation to equity and is most heavily tilted towards banks (7.7%), pharmaceutical companies (6.4%), and oil and gas firms (6.0%).

“Signs of the investment community’s growing interest in ESG are manifest,” said the report, “and include continued growth in the volume of managed assets that incorporate ESG research, increasingly sophisticated integration approaches, and the integration of ESG factors across asset classes.”

In order to manage ESG risks, the study recommends pension plans include the following courses of action 

  • Include Allocation to Passive ESG trackers in Default Fund. Passive trackers that follow an ESG index are a cost-effective solution for plans looking to manage ESG risks in their default fund.
  •  Incorporate ESG Risk Analysis into Global Equity Allocation Model. DC pension schemes can reduce ESG risk in their default funds by tilting toward UK equity. “FTSE 100 companies score favorably in Sustainalytics’ rating model due to their relatively advanced ESG policies, programs and disclosure practices,” the study said.  
  • Develop Forceful Stewardship Strategy. Stewardship strategies typically involve engaging with investee companies to encourage responsible social and environmental practices, and developing proxy voting guidelines.  “Forceful stewardship is thus a critically important part of minimizing ESG risk, even if a passive ESG strategy is also in place,” according to the study.

 By Michael Katz

 Key ESG Issues in a Typical Default Fund

Industry

Portfolio weight

Key ESG issues

Banks

7.7%

Business ethics, Data privacy and security, Human capital

Pharmaceuticals

6.4%

Business ethics, Human capital, Product safety

Oil and gas

6.0%

Community relations, Effluents and waste, Health and safety

Food products

5.3%

Healthy living, Product safety, Water use

Software and services

4.3%

Business ethics, Data privacy and security, Human capital

Source: Sustainalytics

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