Underfunding Drives Pension Investment Strategies

March 13, 2013 (PLANSPONSOR.com) Companies’ decisions about their defined benefit (DB) pension plans are being driven by desires to shed pension risk and the need to generate enough investment returns to fund long-term liabilities.

According to Greenwich Associates latest U.S. Investment Management Study, average funding ratios for U.S. corporate pension funds fell to 81% in 2012 from 89% in 2011, driven mainly by declining interest rates. More than 60% of all corporate DB pension plans are now funded at 85% or less, and only 10% of plans are fully funded.  

Greenwich Associates research shows striking differences in portfolio allocations between well-funded and underfunded plans. Among the 12% of U.S. corporate funds with funding ratios of 105% or higher, fixed income currently makes up approximately 61% of their investment portfolios. Meanwhile, funds with ratios of 75% or less allocate only 31% to fixed income. The difference in equity allocations is equally stark.  

“While plan sponsors with weaker funding ratios have found their intentions to move in a similar direction stymied, many have used the past two years to put in place dynamic allocation plan and glide paths for de-risking as interest rates rise and/or funding levels improve,” said Greenwich Associates Consultant Goran Hagegard.   

Public pension funds are attempting to improve investment returns by shifting assets into riskier asset classes. They are moving in this direction because they are underfunded, they face an environment of declining investment returns and they see little hope of cash infusions from struggling municipal and state plan sponsors.

“Results from our study show that from 2011 to 2012 public funds generally made no progress in closing funding gaps,” said Greenwich Associates Consultant Andrew McCollum. Average solvency ratios of U.S. public defined benefit pension plans held steady at 77%, and Greenwich Associates estimates show that nearly three-quarters of plans are significantly underfunded. Over that same period, public funds decreased their average actuarial earnings returns on plan assets to 7.5% from 7.9%.  

Endowments and foundations appear to be doubling down on the so-called “Yale Model” by planning significant new investments in alternative asset classes and reductions in allocations to traditional equities and fixed income.  

The mix of traditional securities versus alternative asset classes went largely unchanged by endowments and foundations from June 2011 to 2012. However, 27% of endowments and foundations say they expect to significantly increase allocations to private equity in the next three years, and 24% plan to make meaningful additions to hedge fund allocations.   

In addition, more endowments and foundations plan to increase allocations to commodities and equity real estate than decrease allocations to those asset classes. Meanwhile, the percentage of endowments and foundations planning to significantly reduce allocations to domestic equities is nearly double the percentage planning increases. In fixed income, the bias toward cuts is even greater.   

Funds’ satisfaction with the performance of their alternative investments will likely hinge largely on the reasons for their allocations. “Endowments and foundations hoping to duplicate the investment returns of the Yale model’s early adopters might end up disappointed,” said Greenwich Associates Consultant Kurt Schoknecht. In the 12-month period ending June 30, 2012, the alternatives-heavy portfolios of endowments and foundations generated average investment returns of only 1%, compared to the 4% average returns produced by public pension fund investment portfolios and the 6% generated by corporate pension funds.