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Letter from the US: Pension equities ebb

The defined benefit (DB) pension funds of the companies in the S&P 500 index are in deficit. At December 2015, these were $376.6bn (€337bn) underfunded, according to Citigroup’s chief US equity strategist Tobias Levkovich. 

The ‘pension issue’ is fuelling investors’ anxiety, but the funding gap – the difference between pension assets and pension obligations – “will not close in quick fashion” if it relies only on the stock market, wrote Levkovich in a recent note. 

In fact, more important than Wall Street is the Federal Reserve and its interest rates, and actuaries and accountants are becoming more key than pension managers, according to a study by consultancy Milliman.

“Roughly $793.3bn of pension assets are in stocks currently, assuming the year-end 2015 figure appreciated by roughly 7% thus far in 2016, using the S&P 500 index as a benchmark,” wrote Levkovich. “There would need to be a more than 45% upward move in equity markets to close the funding gap without an increase in discount rates to decrease the pension obligation.” 

But such a move is unlikely, given Levkovich’s expectations of modest mid-single-digit gains from equities, and the trend in asset allocation is towards more fixed income.

“Pension funds appear unwilling to allocate assets towards stocks after two major equity pullbacks in the past 15 years clobbered pension programmes, leaving allocators and consultants relatively risk averse with LDI (liability-driven investing) taking over the mindset,” Levkovich wrote. 

“Moreover,” he added, “current Employee Retirement Income Security Act (ERISA) requirements call for companies to keep enough short-term cash and equivalents available to pay out current pension liabilities. Fortunately, corporate cash flow, free-cash flow, earnings and cash holdings are at or near record highs making required cash contributions to pension funds a much more manageable expense.”

S&P 500 pension plans’ allocation to equities slid to 42.4% in 2015 from 44.5% in 2014 and 50% in 2009. “The S&P 500 has appreciated by more than 200% at the end of 2015 since the low in March 2009 but the aggregate underfunded status in December 2015 is 22% higher than the $308bn underfunding peak seen in December 2008,” Levkovich pointed out. The current pension funding status – the ratio between assets and obligations – for the S&P 500 constituents is 81.5%, down from the 87.8% level seen in 2013. 

As Levkovich noted, low yields on long bonds mean lower discount rates and a higher actuarial net present value of pension obligations. 

The diminishing significance of equity returns is confirmed by a recent Milliman report. “Despite a disappointing 2015 investment return of only 0.9%, the year-end 2015 funded ratio managed to increase slightly to 81.8% from 81.7% a year ago due to a 25bps rise in discount rates (from 4% in 2014 to 4.25% in 2015) and an update to life expectancy assumptions,” it says. 

It adds that a refinement of the mortality study of the US Society of Actuaries in October 2015 shortened life expectancy by a few years and, together with the increased discount rates, resulted in a liability decrease of $94.5bn. Two good examples are IBM and General Motors – their pension liabilities fell below the $100bn pension obligation mark, which helped their plans to improve their funded status even though they had investment results of -0.1% and 2.3%.

Funding status could improve this year by the adoption of a spot-rate approach, using the individual spot rates on the corporate bond-yield curve to develop actuarial liabilities. Some 37 of the 100 companies in the Milliman 2015 filings to the Securities and Exchange Commission indicated that they plan to adopt this approach.

Under this method, costs are developed using the individual spot rates of the yield curve for each year of expected costs. So with the current upward-sloping yield curve, payouts expected in the future are valued at higher rates.

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