Market volatility in Q1 2020 has contributed to a steep drop in funded status post year-end, leaving the aggregate system-wide funded ratio around financial crisis levels. In the Q&A below, we provide some observations around recent market events, what it means for pension plans, questions we are hearing from clients and actions policy makers and plan sponsors may be contemplating in the current environment.
Our work as of mid-March suggests that the aggregate funded status of the US corporate defined benefit (DB) system had fallen to around 78% from 87% as of the end of 20191. To put that in context, during the height of the financial crisis at the end of 2008, the aggregate funded level was 79% and, at the end of 2012 after the Federal Reserve’s “Operation Twist” had been implemented, it was 78%. This speaks to the magnitude of the current situation for many pension plans and their sponsors.
Every plan’s asset allocation is obviously different and, therefore, individual results will vary. However, when we look across the aggregated asset allocation for all US corporate DB plans, through mid-March we estimate a year-to-date decline of around 17%-18%. The decline in global equities has been sharp and painful, but almost every asset class outside of interest rates has posted a loss year-to-date.
Plans that had more rates exposure will have likely done better, while those with more equity exposure may have done worse. For example, a 70%ACWI/30% Agg portfolio would have been down around 21%, while 50%ACWI/50% Long US Treasuries would have declined only around 14%. Individual results will vary greatly not only due to differences at major asset class levels, but also sub-asset class levels.
It has been an equally wild ride for the liability side of the funded status equation. Earlier in the year as interest rates collapsed, we estimated that accounting discount rates, had they been set at that time, would have fallen around 70 basis points from an already historically low average of 3.3% at the end of 2019. More recently, as credit spreads widened considerably and interest rates rose, we estimate that discount rates would actually be up around 70 basis points year-to-date if they were being marked now. This has helped to lower the valuation of plan liabilities and has offset some of the aforementioned declines in asset valuations.
Questions around LDI programs have probably been the most popular topic of conversation in recent weeks. In the current environment, some plan sponsors have been questioning whether now is the right time to be implementing a LDI strategy. Others that had previously established one several years ago may be wondering if they should be liquidating them now given the fall in interest rates. Every plan’s situation is different, but we would note that while interest rates have fallen dramatically over the past two years, there is still more room for them to potentially fall further, as has been demonstrated in Japan and Europe. In addition, widening credit spreads potentially increase the attractiveness of corporate bonds even if US Treasuries appear less attractive.
While we believe staying the course with LDI programs may be an appropriate approach for many plans, it may be prudent to revisit the underlying composition of the portfolio. For example, at certain levels of interest rates and credit spreads, it may be appropriate to shift the portfolio away from the former and towards the latter. In addition, the use of derivatives may be an appropriate capital-efficient way for some plans to move to a higher hedge ratio without diverting capital from return seeking assets like public equities.
We estimate US corporate DB plans may be underweight around $100 billion of global equities. When it comes to rebalancing estimates, we would need to make a number of assumptions. In particular, for purposes of this exercise, we have assumed that no rebalancing had occurred earlier in the quarter and that any rebalancing is intended to bring plans back to the asset allocations they had at the beginning of the year.
The timing of rebalancing actions appears uncertain. Given the wild daily swings in financial markets, combined with significantly wider bid/ask spreads in the fixed income markets, some may choose to hold off on any notable rebalancing until markets calm down and then leg into rebalancing activities over several months or quarters.
Separately, US corporate DB plans are certainly not the only retirement-related investors that are likely underweight global equities today. We estimate US public DB plans are underweight around $150 billion, while target date funds in defined contribution plans are underweight approximately $80 billion. As with corporate DB plans, the timing of rebalancing actions by these investors may be uncertain given current volatility in the financial markets. Nonetheless, this speaks to the potential demand for global equities that may reappear at some point.
First and foremost, we point out that rebalancing is not re-risking in this discussion, but rather a risk management tool. The dramatic fall in equity prices has been sharp and painful for many plans, but we view rebalancing back to strategic targets, at some point, as an appropriate tool in the pension risk management toolbox.
Even as a number of plans have reduced their allocation to this asset class in recent years as part of a de-risking program, equity risk may still dominate the asset-only side of their portfolio. We suspect some plans may re-examine the underlying composition of their equity allocations given recent volatility. We note that there are several strategies that can be implemented to help change the distribution of equity returns without reducing the allocation to the asset class. While we would argue that many of these strategies are strategic as opposed to tactical, and therefore may be applicable in any market environment, we acknowledge that some plans may be more receptive at this moment given recent volatility.
During previous periods of stress for corporate pensions, the US government has, at times, displayed a willingness to provide relief around funding requirements. It did so after the September 11th terrorist attacks (Job Creation and Worker Assistance Act of 2002), during the financial crisis in 2008 (Worker, Retiree, and Employer Recovery Act of 2008), and again in 2012 after “Operation Twist” (Moving Ahead for Progress in the 21st Century Act, aka MAP-21). All of these legislative actions helped ease contribution requirements for plan sponsors during periods of stress.
The funding relief originally implemented under MAP-21 has been extended several times and is still effective today, which is part of the reason why many plans have had little to no contribution requirements in recent years. Nonetheless, the current relief was scheduled to begin to wear away in 2021, ultimately winding down in full a few years later. Even before the current crisis, there were already proposals being floated in Washington to extend funding relief again given that, among other factors, interest rates in late 2019/early 2020 were below 2012 levels when MAP-21 was passed. This may be a topic that receives increased attention in the near term if funded levels remain depressed.
However, even if funding relief was extended again, absent additional policy actions sponsors would be liable for higher premiums due to the PBGC on their wider deficits. That premium has been rising in recent years and currently stands at 4.5% of the deficit, based on the PBGC’s definition of the liability, subject to a per participant cap. This is partly why in recent years, even though mandatory contribution requirements have been low, some companies have made substantial voluntary contributions. Oftentimes part of the motivation for those contributions has been to minimize or eliminate PBGC variable-rate premiums, as a growing number of sponsors have linked minimizing or eliminating these premiums to their contribution strategy.
In the immediate term, given other priorities right now in Washington, addressing pension funding relief may not be at the top of the list for lawmakers. As such, there have been some proposals to essentially call for a “time out” on funding requirements, benefit restrictions and increased PBGC premiums during 2020. This could provide some near-term flexibility for sponsors while allowing lawmakers to address pension funding relief issues later this year. Things are changing on a day-to-day basis, and sponsors should be monitoring these developments closely and consider communicating their views if appropriate.
When the dust settles, borrowing in the capital markets to fund a pension plan may make sense for some plan sponsors. Sponsors can make low interest rates work for them by potentially borrowing in the capital markets, contributing the proceeds to the plan, and investing in a liability-matching portfolio. This essentially swaps one debt (pension debt) for another (issued debt), but may enable a sponsor to minimize or eliminate the aforementioned PBGC variable-rate premiums. A number of plan sponsors have executed this strategy in recent years. As the gap between the cost of the PBGC premium and the cost of borrowing has widened, the math appears even more compelling now.
We have previously written about the many benefits that accrue from contributing to a plan, even if not funded through a debt offering. These include the potential to accelerate de-risking actions given an increase in funded status, reduction of PBGC premiums, the typical earnings accretive nature of the contribution and the general ability to recognize a tax deduction on the contribution (consult your tax advisor).
Post the 2008 financial crisis, a number of US corporate DB sponsors made contributions of company stock to their plans. Such contributions are subject to a number of ERISA rules which should be reviewed with counsel, including a requirement that qualifying employer securities may not exceed 10% of plan assets at the time of acquisition. During the years after the financial crisis, contributions of company stock may have been motivated by: 1) a desire to conserve cash; and/or 2) a belief that company equity was undervalued. Given the precipitous drop in funded levels and the general uneasiness around the state of the economy, it will be interesting to see if some sponsors consider this approach just as a number did in the 2009-2010 period.
First, some may be re-visiting what is an optimal hedge ratio for their plans. The fall in interest rates in both 2019 and 2020 has magnified the asset/liability mismatch that many plans maintain in their portfolios. This may be especially true for open plans that, by definition, may have a longer liability duration and, therefore, may have been more sensitive to the decline in interest rates in recent periods.
Second, while these are uncertain times, one thing that has always been certain for plan sponsors is the benefit payments that need to be made to retirees on a monthly basis. In the current environment, some sponsors may need to liquidate parts of their portfolio, potentially at inopportune times, in order to fund outflows. A cash flow matching strategy that aligns a portion of a plan’s assets with several quarters or years of expected benefit payments may allow a sponsor to ride out extreme market volatility without having to make undesired or costly liquidations of existing portfolio assets.
Finally, we have highlighted several periods over the past few years when funded levels had risen, potentially opening the door for sponsors to take de-risking actions in their plans. Most directly with respect to asset allocation, this may involve reducing exposure to public equities and increasing exposure to fixed income to better align plan assets with liabilities. While some plans certainly did make those moves at those times, others did not. This most recent fall in funded levels may lead some sponsors to re-visit their governance structures to make sure they have procedures in place to take actions on de-risking activities when the markets provide those opportunities.
1 Analysis as of March 18, 2020.