US Corporate Pension Review and Preview: The Return of Volatility

Executive Summary

Glancing back at 2018, the funded status of US corporate defined benefit (DB) plans rose significantly intra-year and reached its highest level since the financial crisis. While some plans may have made intra-year shifts in asset allocation to preserve these gains, we suspect some may not have been able to before the return of volatility in the fourth quarter. Looking forward to the year ahead, a few themes stand out including the continued trends of risk transfer and de-risking, as well as the increasing importance of liquidity management. In this piece, we provide observations around how corporate DB plans ended 2018 and the strategies they may employ in 2019.

Glancing Back: Funded Status Gains Likely Deteriorated in 4Q

Volatility is a reminder of the importance of a strong governance structure and the need to be nimble. In early October we issued a note highlighting that notable contribution activity combined with rising interest rates and equity values year-to-date had led to a significant rise in funded levels and provided a strong incentive for plans to engage in de-risking activities.¹ By our estimate, at the end of September 2018 corporate DB funded levels had risen to 91%, a 10 percentage point improvement from the end of 2016 and the highest level since the financial crisis.

The opportunity to lock in such gains is often fleeting, and unfortunately the volatility in the fourth quarter demonstrated just how fleeting it can be. As seen below, we estimate the funded status of the aggregate US corporate DB system fell precipitously at the end of 2018, finishing slightly below where it began the year. Obviously individual plan results will vary based on a sponsor’s asset allocation, hedging strategy, contribution activity and size of benefit payments in 2018. This demonstrates the importance of having a strong governance structure in place to be nimble and to take de-risking actions when the opportunity presents itself.

As we outline later in this note, we do believe some plans increased fixed income allocations last year, potentially in response to the intra-year rise in funded levels. However, others may not have been able to effectuate changes to asset allocation and hedge ratios before the fall in equity prices and interest rates in 4Q. We will have a greater sense of the asset allocation and funded status of most plans when we conduct our 17th annual pension review over the next few weeks as sponsors file annual reports with the Securities and Exchange Commission.

4Q Volatility May Have Eroded 2018 Intra-Year Funded Status Gains

Source: Company annual reports, Thomson Reuters, Goldman Sachs Asset Management.

Significant funding was a key theme in 2018, although that may have only prevented a larger fall in funded ratios. Robust voluntary contribution activity spurred by tax reform and rising PBGC variable-rate premiums helped to augment funded ratios through the first three quarters of the year. While rising interest rates were also helpful from the liability side of the equation, in many respects this only served to offset increases to the liability from new benefit accruals and interest costs, as well as negative asset returns. As seen below, absent the notable contributions we witnessed in 2018, funded levels would likely have fallen significantly further.

Many Factors Served To Offset System-Wide Funded Status In 2018

Source: Company annual reports, Thomson Reuters, Goldman Sachs Asset Management. Past performance does not guarantee future results, which may vary.

Moving up the glide path, at least earlier in 2018. We suspect many plans increased allocations to fixed income due to increases in funded status earlier in the year, whether contribution-related or otherwise. While most sponsors only report asset allocation once a year, and those disclosures will generally be made publicly available during the first two months of 2019, there are a few pieces of evidence we can point to of increased fixed income activity by this investor base during 2018. However, as discussed earlier, not all sponsors may have been able to shift asset allocation before the fall in funded levels in 4Q.

1. Increased US Treasury stripping activity:

Corporate pension plans are natural buyers of US Treasury Strips for their duration characteristics. We believe that much of the increase in stripping activity, as seen below, was due to demand from US corporate pension plans.

Demand for US Treasury Strips Has Increased Notably

Source: Bloomberg, data as of December 2018.

2. Anecdotal evidence from plan specific disclosures:

Intra-year disclosures from plan sponsors, or disclosures from off-calendar year companies that have recently filed annual reports with the Securities and Exchange Commission, have provided plan specific examples of increases to fixed income allocations during 2018. While admittedly these are anecdotal, they do provide evidence of plans that have made moves to notably increase the allocation to fixed income during 2018.

Examples of Activity We Observed in 2018 of Plans Increasing Fixed Income Allocations

Higher funded levels have contributed to increased risk transfer. Increased funded levels earlier in the year likely helped to contribute to another strong year for risk transfer. As seen below, based on data from Life Insurance Marketing and Research Association (LIMRA), 2018 is on pace for a similar dollar amount of group annuity sales as 2017, itself the highest dollar amount of activity since 2012. During 2018 we saw a number of organizations effectuate their second sizable risk transfer over the past few years. This included International Paper, Ball Corporation and Boise Cascade. We would expect others that have completed risk transfer transactions in the past to also explore a return to this market as many sponsors continue to focus on shrinking both the size of their pension obligations as well as the number of participants in their plans. As we have written at length in the past, much of this is incentivized by the continued rise in flat rate premiums paid to the Pension Benefit Guaranty Corporation based on the number of participants in the plan.

2018 Appeared to be Another Robust Year for Risk Transfer Activity

Source: Life Insurance Marketing and Research Association, Goldman Sachs Asset Management. 2018 estimate as of December 2018. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.

Looking Forward: What We Are Watching for in 2019

Construction Ahead: Putting Together the LDI Portfolio May Become More Challenging. While many corporate DB plan sponsors will continue to focus on building out their fixed income portfolio and increasing their plan’s hedge ratio, actually putting together that portfolio may become more challenging going forward. We cite several reasons why this may be the case:

Potentially lower investment grade corporate bond supply, in particular at the long end, after a multi-year period of robust issuance,
Supply that is not well diversified through the economy, leading to industry concentration,
A greater percentage of investment grade bonds rated BBB than in the past, meaning sponsors may need to hold a lower quality portfolio than they may have had to previously, and
We're likely closer to the end of the credit cycle than the beginning, potentially contributing to increased downgrade activity.

This all suggests a more challenging environment to construct an LDI portfolio and highlights the potential benefits of engaging an active LDI manager with experience in constructing appropriate portfolios. It may also lead some sponsors to contemplate other asset classes outside of corporate credit that may be utilized as part of a liability hedging program.

The Next Wave of Risk Transfer: Full Plan Termination? As highlighted earlier, the trend of risk transfer continues, with more plans coming back to market to do multiple deals. While many sponsors have, in the past, focused solely on retired participants for these transactions as this cohort tends to command the smallest amount of premium from an insurer, we see evidence that sponsors (and insurers) may be more willing to explore transactions that involve active and terminated vested (TVs) participants. Participants involved in Bristol-Myers’ recently announced multi-billion dollar full plan termination were predominately actives and TVs, which is not surprising given the company is another example of an organization that had completed a previous annuitization in 2014, which involved solely retirees, and has now come back to market again. Transactions that expand out to include more actives and TVs may be the next wave, whether it involves a full plan termination or not.

De-Risking More Than Just Bonds: Considerations for the Return Generating Portfolio. Many plans have put in place the strategy for the fixed income side of their de-risking program, and are set to execute on it over the next several years. But as these programs become more developed, sponsors are starting to focus on what the return generating side of their portfolio should look like. This has been further spurred by the recent market volatility and has contributed to increased interest in strategies such as defensive equity, low volatility equity, alternative risk premia, and hedge fund replication. We have also seen more sponsors consider the use of derivative overlays for the hedging portfolio, which allows more capital to be allocated to the return generating portfolio, potentially increasing returns at a similar level of risk. We suspect more sponsors will take a closer look at this side of their de-risking programs in 2019.

Out the Door: Managing Liquidity Increasingly Important as More Plans Cash Flow Negative/Cash Becomes a Strategic Asset Again. Even with notable contribution activity, most corporate DB plans are cash flow negative as they pay out more in benefit payments than they receive in from their sponsors. This is a dynamic that will likely continue in future years as more plans mature. This could argue for sponsors to hold more cash in order to fund outflows and avoid liquidating other components of the portfolio, in particular during what may be deemed to be inopportune times. In addition, holding more cash or short term investments may become more palpable for sponsors as yields rise and as cash potentially becomes a strategic asset class again with an associated return component.

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