In 2012, credit spread tightened when equity markets went up, which caused discount rates to fall and liabilities to increase, Karin Franceries, executive director of J.P Morgan Asset Management, told PLANSPONSOR. Credit spread, in simple terms, is the difference between the U.S. Treasury rate and corporate rates. Companies must offer higher return on their bonds, for example, because their credit is not as good as the government’s.
Because companies have so much liability, they are sensitive to any market movement. If discount rates tightened by 50 basis points, for example, the plan would need risky assets (i.e. anything that is not fixed income) to generate 11% returns just to maintain its funded status of 83% at the beginning of 2012, Franceries said. “This is the challenge of having an underfunded pension fund, which is very sensitive to changes in interest rates,” she added.
To combat this problem, Franceries suggested plan sponsors have an aggressive growth portfolio combined with a long-duration strategy. Sponsors should ensure their plans’ fixed-income portfolios have a duration that can help mitigate interest rate exposure.
Last year also saw many risk transfers with lump sum offerings, which Franceries predicted will continue. In 2012, a number of major plan sponsors offered cash-out options to their former employees, and in some cases, to current retirees. This trend is expected to continue in 2013 and beyond, according to global consulting firm Mercer. “Sponsors planning to implement these strategies in 2013 should begin planning now to maximize the effectiveness of the program,” the company said in a statement.
Last year was a tipping point, Franceries said, because plan sponsors finally had enough of pension deficit. The $400 billion deficit in U.S. corporate pension funding is still as large as in 2008, despite sizable contributions from plan sponsors and strong asset returns from the markets, Franceries explained.
Although pension assets grew by more than $1 trillion over the past four years ($700 billion of investment return and $300 billion of contributions) and assets delivered on average 13% return per year over that period, liabilities remained unchanged. This is because the size of the deficit bathtub has increased to a swimming pool as a result of interest rates, she said.