Market volatility is not new to defined benefit (DB) plan sponsors. The market volatility caused by the novel coronavirus pandemic, however, is unlike anything they’ve ever seen.
Brian Donohue, partner at October Three Consulting, based in Chicago, says he believes DB plan sponsors have learned some things about risk in this century. “If we look at 1999 before the dot-com bubble burst, more sponsors were taking risk; they held 70% or 75% in equity. After that crisis, sponsors learned not to creep too far out on the risk continuum. So, when 2008 [the Great Recession] came along, they were not as exposed to the stock market, and evidence shows that since then sponsors have not increased their allocations to risk,” he explains. “There hasn’t been a wholesale movement to LDI [liability-driven investing], but I would bet most plans have only 50% to 60% or less of assets in stock. They may have been better prepared to weather this downturn.”
Donahue says if DB plans were just invested in bonds, they would have been insulated from the major swings in the market. “That’s always been the case and always been an option for DB plan sponsors—to just invest in bonds. That’s the idea behind the liability-driven investing glide path; once a plan hits a certain funded status trigger, more assets are moved into bonds to preserve the funded status,” he says.
Jeff Passmore, director, client portfolio manager and LDI strategist at Barrow, Hanley, Mewhinney & Strauss in Dallas, Texas, says plans using liability-driven investing are faring “quite a bit better” than those that aren’t using it. “The bond portion of any DB plan’s portfolio is doing what it should—reducing volatility and protecting asset returns,” he says. “Thinking about risk beyond asset losses to funded status, bond portfolios are helping to protect funded status.”
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Passmore speculates that a lot of plan sponsors had been hoping that the great bull market would continue, so they left some risk on the table. “They are probably regretting that now since the high-water mark in terms of funded status—according to Barrow Hanley, 88.7%—was at the end of last year.”He explains that triggers for de-risking are usually spaced out 5 percentage points, so a plan sponsor just short of a 90% funded status trigger is probably regretting not taking risk off the table. “In my estimate, funded status went down more than 10%,” he says.
Plans with LDI are doing much better primarily because of bond investments, but how they are implementing their bond investment matters, says NEPC Partner and corporate practice group member Brad Smith, based in Atlanta. “Treasury bonds have done very well year to date. Long credit is positive but not as strong because credit spreads have widened,” he explains. “So not only has an LDI strategy helped DB plans, but those with Treasury allocations rather than just long credit allocations have fared better.”
Not the Same Messages
Donohue says pension consultants are in an interesting situation right now. “Our first reaction is to tell clients, ‘There’s a hole in your pension plan and you should think about filling it,’ but for most companies, the pension plan doesn’t rank first in terms of all they are worrying about right now,” he says. “Some may be worried about making payroll or whether their company will survive, so understandably there’s a premium on cash. Firms don’t know what’s going to happen. Filling in for losses may be more front of mind for those working on the plan, but not for the overall company.”
In addition, for a company on a glide path that was 90% funded and maybe 70% invested in bonds but is now 85% or 80% funded after the stock market drop, Donohue says logic would indicate it should put more money in stocks. “But not a lot of people are hawking that idea,” he says.
Donohue adds that during the depth of bear markets in March 2002 and March 2009, it was a good time for DB plan sponsors to move more assets into stocks. “The idea was that as we climbed out of the bear market into a better year, DB plans would have a better rebound with more assets in stocks,” he explains. “There’s logic to it, but it’s a tough conversation and tough sell right now.”
Passmore says most plan sponsors using an LDI glide path with defined funded status triggers to take de-risking steps think of their de-risking journey as a one-way street, so most have decided they do not intend to re-risk. However, a minority have come to the opposite conclusion and will move to more return seeking assets as funded status goes down.
“Corporate plan sponsors are relatively slow to make changes, so they will make decisions in a couple of weeks as they have meetings and their consultants make recommendations,” he says.
There are several approaches to reduce pension funded status volatility that have been touted, Passmore says, “but what we’ve seen is most return-seeking assets have very correlated downsides—as the stock market experiences a sell-off, so do return-seeking assets.”
Specifically, Donohue mentions DB plan sponsors’ interest in private equity and hedge funds. Private equity is similar to investing in emerging markets, he says—there’s more risk and less liquidity so the assumption is it will result in a better return. As for hedge funds, Donohue notes they did very well in the last financial crisis but have fared less well since then. “I haven’t seen any hedge fund data for first quarter yet. Returns are probably not great, but better than the stock market,” he says.
Passmore says long-duration corporate bonds are thought of as the gold standard for preserving pension funded status in down markets—yields correspond with DB plan liabilities; it’s the ideal hedge.
A flash poll by NEPC found the majority of plans are not taking any actions right now related to the market volatility caused by the pandemic, but 35% of plans with less than $1 billion in assets and one-quarter of plans with more than $1 billion in assets indicated they are rebalancing to their target allocations. Smith says during prior market crises, NEPC clients did rebalance but at a measured pace. However, the speed of this drawdown was faster than what many expected.
“With the current volatility, plan sponsors don’t want to trade today then have to reverse it,” he says.
A small percentage of plans in the flash poll indicated they were taking actions to raise cash. He says that is what NEPC is advising clients to do right now. If they have a mature plan with material payments, NEPC recommends a 1% to 2% cash holding.
Considerations for DB Plan Contributions
As for the hole consultants would usually tell plan sponsors to think about filling, Donohue says one of the “useful messages we are trying to put out is that anything that’s happened in 2020 will not affect contributions until April 2022.” In an article on October Three’s website, Donohue says, “Funding requirements for 2020 for a calendar year plan were locked in as of January 1, 2020. 2020 asset declines may affect minimum funding as early as 2021. Interest rate declines won’t show up in minimum funding numbers until 2023. If they persist.”
The bottom line is there is no need for an immediate cash response to what is happening now, he says, which is good to know because plan sponsors have other concerns right now.
Donohue also mentions the relief provided in the Coronavirus Aid, Relief and Economic Security (CARES) Act. Section 3608 of the CARES Act provides a delay for minimum annual required contributions (ARCs) that would otherwise be due from single-employer DB plans during this calendar year. The new due date for any such contribution is now January 1, 2021.
Yet, Donohue says, he is always talking to sponsors about why it makes sense to put money in their DB plans. “On September 15 of this year if they can swing it, sponsors should consider putting money in their plans for the same reasons as always—being underfunded and major PBGC [Pension Benefit Guaranty Corporation] premium costs. But as always, they will weigh that against other clamors for cash,” he says.
Asked whether DB plan sponsors may consider making additional contributions to make up for market losses, Passmore notes that for most plan sponsors, contribution requirements are quarterly with the largest due at the end of the third quarter, so sponsors have a little bit of time.
However, he says, “I don’t think anyone is prioritizing pension contributions at this time. What we have seen in the last several weeks is companies issuing bonds and tapping credit lines in record numbers, so I think companies are doing what they can to create cash reserves to handle expenses until the economy comes back around. Pension plan contributions tend to fall much lower on companies’ list of priorities and can wait until a later time,” Passmore adds.
While the CARES Act included a provision to allow some plans to avoid triggering certain benefit restrictions in 2020 that would otherwise apply if their funded status falls below 80%, it did not include funding relief as seen in prior market crises. Passmore says he wouldn’t be surprised if Congress passed some additional funding relief for DB plans, since such moves have been typical during certain market events. He says he expects some broad funding relief as well as perhaps more targeted funding relief. “For example, airlines post-9/11 were given more relief, and that is beginning to sunset,” Passmore says. “Given what they are facing now, I would not be at all surprised to see more targeted relief for airlines and potentially other hard-hit industries.”
The bottom line is there’s a huge amount of uncertainty right now, Donohue says. “It’s such a volatile period it’s hard to make too many specific, concrete decisions. Waiting and seeing might be the best thing to do right now,” he says.
Smith says the most important thing for DB plan sponsors is to stay disciplined. Rather than a specific target, plan sponsors’ allocations should stay within target bands. “The stock market not only sells off before a recession but recovers before we get out of a recession,” he notes. “If a plan’s allocation is outside target bands, plan sponsors need to rebalance and get closer to the target, but don’t trade just to trade.”
Passmore says this event and other great financial crises point to the importance of understanding financial risk taking in DB plans—ensuring plan sponsors are comfortable with the risk and looking at to what extent they are not managing it. He adds that the primary way to manage risk is an LDI approach using glide paths.
Passmore suggests DB plan sponsors work with their partners—consultants, outsourced chief investment officers (OCIOs), investment managers—to monitor funded status and facilitate quicker moves at triggers so opportunities are not missed.
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