The funded status of corporate defined benefit (DB) pension plans in the U.S. year to date has notably improved in the wake of a rise in bond yields and equity markets, said Michael Moran, pension strategist at Goldman Sachs Asset Management.
Based on Goldman Sachs’ analysis, the aggregate funded status of the plans of S&P 500 companies has risen to more than 85% as of late June, significantly higher than levels from the end of 2012, Moran said in a white paper, “Rising Funded Status: Time for Glide Path Implementation?”
A key question for plan sponsors that Moran explores is what to do now.
“A glide path strategy would call for asset allocation and investment strategy to change as certain factors, such as pension plan funded status, change,” Moran told PLANSPONSOR. Several plans have adopted glide path or dynamic asset-allocation strategies that call for adjustments to their portfolios as funded levels and/or bond yields rise. These adjustments could entail adding to and/or extending the duration of their fixed-income holdings as well as reducing exposure to equities or other return-seeking assets.
According to Moran, rising bond yields, lowering the present value of pension obligations, and higher equity values, augmenting the value of plan assets, have been helpful for both sides of the funded status equation. Research from the firm’s investment strategy group indicates bond yields and equity prices can rise at the same time when the risk-free rate is at a low level. This scenario has played out over the past few months, he said. If it were to continue, it could result in even further improvements to corporate funded levels.
Moran reviews where funded status for U.S. corporate DB plans has moved year to date and how much higher bond yields would need to rise in order to return the system to a fully funded level. He examines why some plan sponsors might want to seriously consider implementing a glide path strategy that calls for de-risking type actions.
A plan sponsor may determine, for example, that at an 80% funded level the appropriate asset allocation is 60% equities and other return-generating assets, and 40% liability hedging assets, Moran said. “The liability hedging assets would be predominately long-duration, fixed-income since those provide the best match for the pension liabilities.”
However, as funded status changes, the glide path strategy would call for that strategic asset allocation to change, Moran noted. “For example, assume that perhaps due to a rise in bond yields and equity markets, funded status for this plan has increased to 90%. At this higher funded level the plan would likely be more focused on preserving that funded status rather than seeking higher returns. Consequently, the glide path may call for an asset allocation at a 90% funded level of 50% equities and other return-generating assets and 50% liability hedging assets. At a 100% funded level, the glide path strategy may call for 40% equities and other return-generating assets and 60% liability hedging assets.”
The main point here, according to Moran, is that as funded status improves the plan sponsor should make changes in the asset allocation that reduce risk. “Since pension liabilities are bond-like in nature, the best way to reduce risk is to have assets that match the characteristics of the liabilities,” he said. “This implies adding to and/or extending the duration of fixed-income holdings as well as reducing exposure to equities or other return-seeking assets.”
Moran suggested various actions a plan sponsors can take when implementing a glide path program. “First, a plan can reduce exposure to equities or other return-seeking assets and replace them with fixed income, since this provides a better match for plan liabilities,” he said.
Second, a plan could extend the duration of fixed-income holdings. “Some plans have fixed-income allocations tied to benchmarks that have a shorter duration than their pension liabilities,” Moran added. “Consequently, they still have interest rate exposure since plan liabilities will change in value more than fixed-income holdings as interest rates change.” By extending the duration of fixed-income holdings to better match the duration of plan liabilities, the assets and liabilities will rise and fall more closely as interest rates change. Often as part of this a plan sponsor may change fixed-income benchmarks to those that have a longer duration.
Finally, Moran said, some plans may consider using derivatives, such as interest rate swaps, as a way to add duration to their overall portfolio. However, he noted plan sponsors vary widely in their willingness to use derivatives in any capacity.