The recent report from J.P. Morgan Asset Management, “Pension Funds at the Dawn of 2014: Catch the Rebound,” finds that in 2013, plan sponsors saw the largest yearly funded status increase in more than a quarter of a century. Also, compared with the previous five years, the aggregate funded status of the Russell 3000 improved by more than 17% from year-end 2012 through November 2013, to 94%.

The report predicts that the funded status of pension funds will rise to 96% by the end of December 2013. Strong growth asset returns are said to be responsible for more than 60% of this improvement, with the balance related to a decrease in the discounted value of liabilities. Plans across the U.S. have seen an increase in funded status, with one plan in five going from underfunded to overfunded in 2013.

The report reveals deficits have fallen by two-thirds from the end of 2012, a decrease of $454 billion, which has more than made up for the deficit increase of $312 billion in the crisis year of 2008. The reduction will boost both reported net income and shareholders’ equity.

The report predicts four main factors will impact plan sponsors including:

• Balance sheets will likely strengthen in 2013. The report estimates that the pension deficit reduction will boost after-tax shareholders’ equity of companies with pensions by 7% on average and cut net debt of companies by a similar percentage. Both effects will contribute to further balance sheet deleveraging.
• Pension costs should improve starting in 2014. The improvements of 2013 will not initially impact net income but will flow through in future years. The improvements will only have an immediate impact for companies that have adopted full mark to market accounting. For them, the funded status increase will show up as income. For the other corporations, the positive effect will start in 2014 and will be smoothed over time.
• Contributions should not be significantly affected. According to the report, contributions are expected to level off, if not decrease, for 2013, despite contributions from plan sponsors committed to de-risking.
• The pension burden should finally lighten up. The report estimates corporate America’s ratio of deficit to market capitalization declined from 6% at the end of 2012 to 1% by November 30, 2013. This is far lower than it was at any time in the preceding five years.

In light of all these factors, how should plan sponsors proceed? “Plan sponsors should capitalize on this increase in funded status,” Karin Franceries, primary author of the report, tells PLANSPONSOR. “They should consider adding more and better liability driven investments (LDIs). However, you do not want your portfolio to be 100% fixed income, because there are still risks. But take action now and don’t wait for the rates to increase.”

Franceries, who is head of the U.S. Strategy Group for J.P. Morgan Asset Management, says plan sponsors should also revisit portfolio allocations, especially with regard to risk tolerance. She advises that plan sponsors use their regular process of assessing risk tolerance, keeping in mind the fact that their tolerance level may either be lower or higher than before.

In the report, Franceries and her coauthors point out that in terms of its risk-return profile, the surplus of a fully-funded plan belongs to that plan. However, resolving the plan’s deficit is the responsibility of the sponsor. With funded status on the rise, plan sponsors have a strong incentive to take risk off the table to avoid what is deemed as a “trapped” surplus.

The report recommends plan sponsors consider:

• Improving liability matching;
• Reassessing how much to increase the fixed income allocation; and
• Reallocating to hedge assets sooner rather than later, despite the market view that rates may increase.

The report also cautions that just because a plan is fully funded does not mean it is “home free” or without issues. Research indicates plans may need more than $100 of assets today to cover $100 of future liabilities because of the uncertainties of longevity, credit and service costs.

With regard to longevity, Franceries points out an increase in the longevity of participants may equal an increase in risk. She adds that longevity is something always uncertain and mortality tables used to calculate it may be slow to catch up with revisions.

Data in the report shows a “tail longevity” scenario, which would double the rate of mortality improvement, would result in a 6% increase in plan liabilities. With regard to credit, the liability discount rate is subject to default and downgrade risks. Today, risk-free valuations are 16% higher than current valuations. This means the typical plan sponsor would need 16% more assets to fully hedge the current value of pension liabilities.

As for service cost, even overfunded plans may need room to grow. Pension liabilities in the U.S. are still rising on average, including for those plans closed to new entrants. The average service cost is 1.8% of liabilities. Without contributions, a plan would need asset growth of 6.9% to maintain a 100% funded status over 10 years. This is close to 200 basis points more than the fully de-risked portfolio’s estimated return.

The report recommends performing reallocation sooner rather than later. Franceries recognizes plan sponsors may be hesitant to do so because they expect rates to increase. “As to how fast this increase will take place, we don’t know,” she says, but notes that a good argument for reallocating now is protection against market volatility.

Research in the report estimates discount rates could rise 100 basis points over the next few years, which by itself could cause the present value of corporate America’s liabilities to decrease 12% to $1.83 trillion and funded status to rise to 109%.

Franceries and her coauthors conclude that plan sponsors’ first priority at this point should be to protect funded status improvements, while minimizing the likelihood of future contribution. In taking the steps recommended in this edition, sponsors can prepare plans to weather volatility when it resurfaces.

The report is discussed in the Fall/Winter 2013 issue of Pension Pulse. More information can be found here.