Letter from the US: DB pensions bond bind
US corporate pension funds are caught in a dilemma. They are buying more and more long-dated bonds to match their liabilities and lower their risks but in doing so they are driving down their yields, which, in turn, makes liabilities look more expensive.
At the end of 2014, large defined benefit (DB) pension plans held more bonds than equities, according to the Milliman 2015 Pension Funding Study (PFS), which analyses the 100 US public companies with the largest DB pension plan assets.
“The majority of CFOs are trying to minimise the footprint and volatility of DB pension funds on their balance sheets,” says John Ehrhardt, principal and consulting actuary at Milliman, and co-author of the 2015 study. “A strategy to achieve that goal is to get rid of volatility with liability-driven investing (LDI). It limits potential gains, with the possible effect of raising the contributions to the funds. But CFOs who adopt this strategy think it’s worthwhile, based on a risk analysis.”
This is not a new development for Mark Ruloff, director of asset allocation at Towers Watson. “DB funds’ movement towards bonds started even earlier than 2008 and the funds that adopted LDI strategies before the financial crisis have had better results,” he points out. “With the 2006 Pension Protection Act, the government, in practice, through new funding rules, discouraged companies from having a long-term investment strategy in equities for their pension fund because, if companies go bankrupt with underfunded pension plans, public money [the Pension Benefit Guaranty Corporation] will have to rescue them.”
It does not matter today if bonds are unattractive, with potential returns that are lower than stock returns, according to Jay Love, a partner and senior consultant at Mercer. “A pension fund strategy depends not on the financial market environment, but on the company’s situation,” he points out. “Stocks have more volatility and risks, while bonds can be used to secure past results. If a pension fund is fully funded, it doesn’t need to grow its assets.”
In fact, the present financial environment is ideal for companies that are trying to reduce risk in their pension plans, according to Ronald Ryan, CEO and founder of Ryan ALM, a Florida-based asset and liability management firm. “Interest rates are at the lowest level in modern history today, and most economists predict higher rates over the next five years. This suggests that future liability growth will be low to negative. As a result, we may be at the best moment in over 30 years to witness a bear market trend in interest rates that should allow non-bond assets to outperform liabilities and enhance the funded ratio. As the funded ratio improves there should be a transfer of assets to the liability cash-flow matched core portfolio to secure and stabilise reduced costs.”
But a bear market in bonds could also spell the end for many DB pension plans. “Approximately one-third of Fortune 500 companies don’t have a DB plan, especially in the tech industry,” says Ehrhardt. “Another third still have active DB funds because they are valuable recruiting tools for them. They are more likely to maintain the philosophy of long-term investments in equities. The remaining companies have frozen their DB plans and eventually will terminate them: the median fund is 84% funded, and their companies are waiting for interest rates to go up, and liabilities to go down, so they can reach 100% funding and close the fund, paying lump sums to participants or buying a group annuity for them from an insurance company.”
While corporate pension funds are reducing risk to comply with funding regulations, public pension funds are in a different situation. “They are exempt from those rules, so they can contribute less and risk more with their investments,” says Ruloff. As a result, public funds have a lower funding level and a higher level of risk compared to the corporate funds. This bifurcation in the US pension industry is quite a paradox.