Letter from the US: Funding under pressure
Wall Street posted record highs in 2014 but this was not enough to compensate for other negative factors affecting US corporate pension plans. Their funding status dropped from 89% at the end of 2013 to 80% by the end of 2014, according to Towers Watson, and the pension deficit increased to $343bn (€303bn), doubling that of 2013. Overall pension plan funding fell by $181bn.
Similar conclusions come from the UBS Global Asset Management US Pension Fund Fitness Tracker: it reported that the average funding ratio declined by 8% in 2014.
This deterioration should motivate sponsors to re-evaluate their strategies and favour liability-driven investing.
“In 2014, funding levels for employer-sponsored pension plans dropped back to what we experienced just after the financial crisis,” says Alan Glickstein, a senior retirement consultant at Towers Watson. The analysis examined pension plan data for the 411 Fortune 1000 companies that sponsor US tax-qualified defined benefit (DB) pension plans and have a December fiscal-year-end date. Pension plan assets increased by an estimated 3% in 2014, to an estimated $1.4trn, reflecting an underlying investment return of 9%.
“Returns were good but the problem was interest rates going down a lot, so liabilities grew much larger,” explains Glickstein. “Moreover, there was a onetime important impact on the pension funded status, due to new mortality tables that project increased life expectancy. Of course, they are assumptions and each pension plan must evaluate which is the best assumption for its members. We estimate that mortality assumptions alone is responsible for about 40% of the increased deficit.”
Another reason is lower contributions. Sponsors only contributed $30bn in 2014, the lowest level since 2008. “Each case is different,” elaborates Glickstein. “Some companies, for example, may have had cash problems. But in general, from 2008 to 2013, US corporations made large contributions to their DB pension plans, because their funding status had been eroded. Then, in 2014, a new law allowed corporations to smooth their liabilities, making them look smaller, so they could delay contributions, and make higher profits, which generate higher corporate taxes.” In any case, corporate contributions are at a good level and they do not create concerns, according to Glickstein.
Plan sponsors that used liability-driven investing strategies in 2014 had better results as declining discount rates were matched with strong returns for long corporate and Treasury bonds. Whereas 10-15 years ago most US pension funds were 60-65% invested in equities, a more common allocation is 50:50. “Managers have been switching to new strategies trying to match liabilities with assets,” Glickstein says. “That means investing in fixed income with a duration that is equivalent to liabilities. It is still rational to have assets in equities and not 100% in bonds, but the trend is definitely towards more bonds in pension funds’ portfolios.”
Another trend is de-risking with buyouts and annuity purchases. “If a pension fund has to value its assets mark to market, it struggles with market volatility,” continues Glickstein. “That, plus the need to lower administrative costs, including higher premiums paid to the Pension Benefit Guaranty Corporation, pushed sponsors to shrink pension plans. To do that, they paid lump sums to participants or transferred the company’s pension obligations to an insurer by buying a group annuity for the employees.”
How much will these improve funding levels? Glickstein is unwilling to predict. “We do not expect another big event like mortality tables. However, their impact has not finished affecting pension funds, because not all sponsors have changed their assumptions. Also, the Congress should not approve any significant new legislation about retirement, but it can always come up with a bill that generates revenues like the one for smoothing liabilities.”