DB Plan Sponsors Appear Better Positioned for LDI

An extensive new “First Take” analysis published by Goldman Sachs Asset Management (GSAM) suggests corporate defined benefit (DB) plan sponsors are likely to increase allocations to fixed income as their funded statuses collectively rise.

Importantly, according to researchers, the increase in funded status experienced in the last year by U.S. corporate DB plans resembles a similar increase seen in 2013. Whereas many pension plans at that time did not appreciably shift asset allocations away from equities towards fixed income and liability-driven investing strategies, the firm argues pension plan behavior “should likely be different this time.”

“In fact, such portfolio shifts could help to facilitate risk transfer actions,” the firm suggests. “Annuity purchase risk transfer strategies accelerated in 2017 and we expect this to continue in 2018 as part of broad de-risking actions.”

The GSAM research suggests 90% of the plans in the survey sample underlying the new analysis posted a year-over-year increase in their funded status as of the start of March 2018. The system as a whole saw a rise in aggregate funded status of over four percentage points, in fact.

According to GSAM, strong asset returns and an increase in voluntary contribution activity drove funded levels higher. On the other side of the ledger, however, lower discount rates did offset some of the gains. Looking across the portfolios of all the plans in the sample, actual allocations to fixed income were only marginally higher than the year before—another indicator that 2018 “may be the year that many plans undertake portfolio adjustments.”

Despite the year-over-year gain, return assumptions among the sample plans continued to move lower, GSAM reports, “albeit at a somewhat slower pace than in previous years.” According to the research, disclosures around 2018 return assumptions suggest the trend may continue.  

Zooming in on the “robust contribution activity witness last year,” GSAM researchers stress that recent corporate tax reform has provided a “strong incentive for sponsors to make contributions sooner rather than later in order to capture the benefits of a larger tax deduction.” Voluntary contributions are also described as a powerful means for reducing or even entirely eliminating Pension Benefit Guarantee Corporation (PBGC) variable-rate premiums, “which have been steadily increasing.”

“We estimate that actual contributions to U.S. DB plans in the S&P 500 universe reached their highest levels this last year since 2012,” researchers explain. “Several companies, including UPS, Lockheed Martin and FedEx, cited tax reform as a motivating factor in making voluntary contributions in 2017 and 2018. We expect strong voluntary contribution activity to continue this year. This view is based on disclosures around what companies expect to contribute in 2018 and our understanding of how actual contributions, in aggregate, tend to correlate with expected contribution disclosures.”

As the researchers see it, the ability to make a contribution through mid-September 2018 and potentially reap a tax deduction at the older, higher rates, will likely play a supporting role in this dynamic.

“One way to think about the contribution activity in 2017 was that, at least at the aggregate system-wide level, contributions accounted for almost all of the year-over-year increase in funded status,” GSAM says. “Contributions positively influenced system-wide funded status by about 3.5 percentage points, while the overall increase in funded status was a little over four percentage points.”

Crucially, much of the positive impact of asset returns simply offset the headwinds to funded status seen from “interest cost, service cost, the drag from outflows for benefit payments and, importantly, actuarial losses from lower discount rates.” By the end of the calendar year 2017, the discount rate used by companies in the sample had fallen to the lowest level measured in this ongoing research series.

The analysis goes on to argue in no uncertain term that the current environment really puts the onus on plan sponsors to consider ways to lock in their gains: “Of all the plans that had a year-over-year incrase in funded status, in 28% of the cases the increase was in excess of five percentage points. Yet within that population, less than one in three have increased the fixed income allocation by at least five percentage points.”

“Why might this dynamic have occurred? We can think of several potential reasons. First some plans may be engaged in market timing,” GSAM warns. “There may be hesitancy to move into long-duration fixed income during a period where the Federal Reserve is raising short-term interest rates, signs of inflation are finally emerging, and there is an expectation by some that long-term interest rates will rise, as they already have in 2018.”

Complicating matters, GSAM says, is that some plans may have yet to even rebalance their portfolios, let alone get around to increasing their strategic allocations to fixed income: “In some cases, it is possible that organizations may not yet have a governance structure in place that can effectuate such adjustments nimbly, potentially leaving them exposed if equity and interest rate volatility were to increase.”

The full analysis is available for download here.