American defined benefit (DB) pension funds may become the next nightmare for US corporations. David Blitzer, chairman of Standard & Poor’s index committee, predicts that pension contributions will replace stock options as the big corporate accounting issue next year. The almost three year severe stock market downturn has deeply damaged DB plans’ assets affecting company earnings, forcing sponsors to pour cash into retirement schemes and also inducing them to re-think their investment strategy.
For the time being, DB pension plans are still buying equities ‘to reinstate their benchmarks, while selling bonds to meet pension payments in excess of contributions’ – writes Michael Peskin, head of Morgan Stanley’s Global Asset Liability Management team, in a special report on this subject. But the bigger story is that strategically (perhaps over the next three to five years) companies will increase their duration of their fixed income positions and most likely reduce equities.
Ronald Ryan, founder of the New York based research firm Ryan Labs, thinks that that could happen even earlier: “Usually pension funds review their asset allocation at year’s end. But I know that big task forces are already working to face the growing difficulties of plans. Besides, the next few months will make much clearer the impact of pension plans’ potential deficits on balance sheets and that will increase pressure to change strategies”. The seriousness of the situation is shown by last month’s ‘Asset/Liability Watch’ issued by Ryan Labs: “September 2002 was the worst month since October 1987 as assets underperformed liabilities by -11.83%. This caused a year-to-date growth rate differential of -36.46%. At this rate, 2002 will become the ‘worst year on record’. Moreover, combining the two last calendar years now has pension assets falling behind pension liabilities by an alarming -73.40%”. In fact the asset-liability mismatch was -28.46% in 2000 (so far the worst year) and it was -8.48% in 2001. Ryan Labs analysts conclude: “Higher contributions, earnings drag, PBGC (Pensions Benefit Guaranty Corp) premium penalty and even solvency issues will confront America’s pensions over the next few years”.
Peskin explains: “Falling interest rates have increased the value of pension liabilities at the same time that declines in equity markets have reduced pension assets. Pension liabilities are cash-flow commitments that extend well into the future, and they behave very similarly to long-dated bonds, with an average duration of about 12 years. Most pension plans are invested in equities and intermediate-duration bonds (with a duration of four to five). There is thus a substantial duration mismatch in the bonds as well as in the large equity-versus-bond allocation”. He simulates what could occur for a typical plan (invested 70% in equity, 30% in fixed income with a five-year duration) if interest rates and equity prices decrease simultaneously in a deflationary environment. If yields decrease by two percentage points and stocks slide by 20%, the funded status will collapse to 74%. “The huge duration mismatch cannot be justified,” comments Peskin. “In our view, bond durations need to be extended significantly (from five to more than 10). Equity allocations, which have averaged about 65% in the US and 70% in the UK, look too large given the risks pension plans now pose to sponsors. We expect equity allocation to drop more than 10 percentage points over the next five years in favour of corporate bonds and alternative investments”.
Nonetheless, pension plans are currently rebalancing their portfolios buying more stocks to stay in line with their long-term investment policies. A recent study by the consulting firm Greenwich Associates, points out that for about 60% of US pension plans rebalancing is an automatic mechanism that triggers selling or buying once an asset class goes outside a target range (usually 3 to 5% on either side) or hits a certain target percentage.
So, since July many pension funds have been net buyers of stocks. “We are buying equities,” confirmed Mark Anson, chief financial officer of CalPers, the largest pension fund in the US, in an interview with Los Angeles Times three months ago. In September, Anson declared the fund was financially sound thanks to its diversification, but it’s reviewing its asset allocation.
According to the consulting firm Wilshire Associates already more than half of all American public pension funds are underfunded, up from 31% two years ago; by the end of 2002 the percentage will rise to 75. The private sector is not laughing. A new study by Credit Suisse First Boston about the 360 companies in the S&P 500 index that have pension plans, estimates that by year’s end total assets will cover only 79% of liabilities.

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