Unprecedented Defined Benefit Plan Funding Levels: Is This As Good As it Gets?
Corporate defined benefit plan funding may be at a historic high, but with unsustainable rates and funding levels it may be time to derisk. Senior Investment Advisor Ramu Thiagarajan explains.
Senior Investment Advisor
For the first time in more than a decade, aggregate funding ratios for US corporate defined benefit (DB) plans are at historichighs (nearly 95 percent, per one year-end estimate), raising a critical question for the $3.5 trillion market: Is it time to derisk?
To answer this question one needs to first understand the macro environment that led to the current state of corporate DB plans. Monetary easing following the great financial crisis (GFC) engineered one of the greatest bull markets in equities and global bonds. Against this backdrop of a very long credit cycle, the pandemic caused a blip. At the beginning of the pandemic, equity markets fell dramatically and risk aversion rose, resulting in widening spreads and a precipitous fall in the funded status of US DB corporate plans. Funding levels for such plans dropped to as low as 75 percent, sending chills throughout CFO suites.
Thanks to the unprecedented monetary and fiscal response, nearly four times the response following the GFC, there was a dramatic rise in the value of all risk assets and global bonds, while spreads and risk premia shrunk and volatility collapsed sending funding ratios soaring. This resulted in funding ratios of DB plans exceeding 90% and remaining there for nearly 10 months ꟷ the longest tenure of elevated funding levels in decades.
The key question now is whether these investment gains and funding levels are sustainable. l believe that these broad investment gains are unsustainable and it is important for sponsors to consider derisking DB plans, particularly in light of the outlook for global macro conditions.
What Drives Defined Benefit Funding Levels?
The primary drivers of DB funding levels are discount rates, investment performance and the time horizon of payouts. Monetary and fiscal policy initiatives since GFC have influenced the first two in unprecedented ways. Since 2009, we have seen accommodative central banks pump trillions in liquidity resulting in an easy credit cycle lasting an unprecedented 12 years. As a result, equities have soared, as have bond valuations, and credit spreads collapsed benefitting the asset side of the pension balance sheet.
Risk premia across asset classes have never been lower. A proxy for the investment portfolio of a typical DB plan has increased by 11.62 percent on an annualized basis since March 2009. For 2021 alone, proxy portfolio has increased by 11 percent resulting in plans being funded more than 90 percent for about 10 months. Juxtaposed with the expected return assumptions averaging around 6 percent, pension plans have experienced substantial gains in the last decade.
Easy monetary policy has also reduced the discount rate used to discount pension liabilities resulting in the ballooning of such liabilities. This increase is a function of the sensitivity of liabilities to changes in interest rate (duration risk). This sensitivity, however, has been decreasing due to the increase in frozen, terminated and closed plans which have risen from 42 percent in 2008 to nearly 72 percent in 2019. Despite the increase in liabilities, the remarkable performance of all assets since the start of easy money in 2009 has resulted in the comfortable position of funding levels observed today.
To Derisk or Not to Derisk?
The decision to derisk is driven by investment performance and discount rates.
Let’s start with investment performance. Equities have had a stellar performance over the last decade and given current levels, expected returns on equities today are not as high as they have been in the last decade. Global monetary authorities have signaled rate increases and thus expected price returns for sovereigns in 2022 is negative.
DB plans invest heavily in Investment Grade (IG) credit and given very tight spreads, expected excess returns for IG credit are paltry at best (50 basis points (bps)) and likely negative. For alternatives, while expected returns are robust, there is higher uncertainty with respect to these returns, as the global economy adjusts to moderate growth with growing inflation and tightening monetary policy. Thus, there are good reasons to lock in gains from the past decade.
How about the impact of discount rates on pension liabilities? The story is a bit more complex here as cyclical and structural factors are at play with conflicting effects. An increase of 100 bps in AA index, which is used to discount liabilities, is expected to decrease liabilities by a meaningful 12 percent. As monetary authorities raise rates, risk premia increase across all asset classes and corporate spreads are likely to widen. This widening naturally increases discount rates and reduces liabilities, benefitting funding ratios and providing a reason to defer derisking.
However, I believe there is greater uncertainty as to the trajectory of discount rates for the following reasons. First, the demand for IG corporate debt is very high, which leads to tighter spreads and caps AA discounts. Second, as central banks shrink their balance sheets (and the associated monetary base) and, importantly, as supply chains ease, inflation is widely believed to revert to the structural story of lower for longer. In this world, the discount rate may not accelerate So the expected gains from higher AA index is uncertain at best.
DB plans inherently have a growth risk built in their exposure as allocations to equities and alternatives in their plans are nontrivial.
Given the substantial gains in the last decade, particularly in growth equity indices, I believe it is prudent to consider limiting this growth risk inherent in DB asset allocation models. This is the first benefit of derisking. The second benefit is behavioral, namely ‘fear of regret’. At 95+ percent funding, the risk of NOT derisking is the regret from a reversal in funding levels. Historically, high funding levels have not lasted long – funding levels were above 90 percent for just four months in 2013 and six months in 2018. We now have a cycle where funding levels are over 90 percent for more than 10 months – investment returns in the next decade are highly unlikely to match those of the last decade.
Finally, there is the issue of volatility of asset-liability profiles. The key volatility metric for DB plans is rate volatility as it impacts the largest component of the asset portfolio as well as, and importantly, liabilities. With central banks globally raising rates to respond to trends in inflation, volatility of rates increases, and by inference, prospective volatility of funded status will also widen. Thus, from a risk viewpoint, it also makes sense to consider derisking.
While there are many strategies to derisk, plans with funding status in excess of 105 percent can comfortably consider paying the insurance buyout premiums which average around 5 percent. Alternative strategies include Cashflow Driven Investing (CDI), Liability Driven Investing (LDI), or some form of tail risk protection for the inherent growth risk in portfolios. Pension obligations are, on average, about 16 percent of the plan sponsor’s market cap but there is dispersion in this number with some plans having a much higher obligation. In particular, for plans where this number is higher and funding status exceeds 100 percent, the present conditions may truly be as good as it gets.
1 The number represents the value of Pension Benefit Obligation as reported to the Fed as of September 30, 2020. This is just for the United States. As per the OECD, the US represents 65 percent of the pension obligations. Scaling the number up, the value of pension obligations globally exceeds $5T.
2 This finding was based on a model allocation of 40 percent to equities (proxied by a linear combination of S&P500, Russell 2000 and Russell 3000 Indices), 45 percent allocation to Bonds (proxied by Barclays US Aggregate Total Return Index) and 15 percent to Alternatives (proxied by MSCI US REIT Index). These allocations are representative of those of an average US corporate DB plan.
3 The calculation for frozen, terminated and closed plans is derived from Willis Towers Watson reports as summarized in the Morgan Stanley Report “Tailwinds from Pension Derisking”, November 8, 2021 – Exhibit