How DB Plans Fare During Volatility Depends Greatly on Portfolio Allocation

Though average corporate defined benefit (DB) plan funded status was relatively flat in June, as Brian Donohue, partner at October Three Consulting, notes in the firm’s June 2020 Pension Finance Update, during the second quarter, “plans clawed back about one-third of the ‘hole’ created in the first quarter.”

Both model plans October Three Consulting tracks gained ground last month, but both also are down for the year. Plan A, a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, improved more than 1% in June, while Plan B, a largely retired plan (duration 9 at 5.5%) with a 20/80 allocation with a greater emphasis on corporate and long-duration bonds, was up less than 1%. For the year, Plan A is down 8% and Plan B is down 2%.

Most firms that track pension funded status found only slight increases for the month of June. For example, Mercer estimated the aggregate funding level of pension plans sponsored by S&P 1500 companies decreased by 1 percentage point during the month to 80%, while Wilshire Consulting estimated the aggregate funded ratio for U.S. corporate pension plans sponsored by S&P 500 companies increased by 0.7 percentage points in June to end the month at 82.7%.

Northern Trust Asset Management (NTAM) found the average funded ratio of corporate pension plans was flat in June, increasing from 79.8% to 80.0%. Jessica Hart, head of the OCIO [outsourced chief investment officer] Retirement Practice at NTAM, explains, “Further tightening of credit spreads led to higher liabilities in June. This liability increase was offset by favorable returns from long credit bonds and equities, resulting in little funded ratio movement. Year-to-date, funded ratios are still down approximately 7%.”

For the quarter, Barrow Hanley estimated the funded ratios of corporate pension plans sponsored by companies in the Russell 3000 increased to 81.4% as of June 30, from 77.9% as of March 31. And Willis Towers Watson examined pension plan data for 366 Fortune 1000 companies that sponsor U.S. DB plans and found an increase of 3 percentage points from 79% at the end of the first quarter to an estimated 82% as of June 30. Willis Towers Watson notes that individual plan results will differ as returns have varied significantly by asset class. “As we move into the second half of 2020, many companies will be facing declining revenue from the impact of the pandemic and higher pension plan costs on the horizon for next year. To navigate this challenge, plan sponsors will need to keep a close eye on interest rates and financial markets, while at the same time review and monitor their funding policy, investment allocation and overall risk management approach as they plan for 2021,” says Eric Grant, senior director, Retirement, Willis Towers Watson.

Portfolio Allocation Matters

According to River and Mercantile’s Monthly Retirement Update, most pension plans should have seen a slight increase in their funded status, although the direction and magnitude will depend on the plan’s investment portfolio and funded status. Plans with larger equity exposure and well-funded plans will have larger funded status improvements for the month, it says. “Equity markets may have finished the month up, but they still are down year-to-date. Coupled with discount rates that are roughly 0.5% lower than where they started the year, and most corporate pension plan sponsors find themselves in a worse spot than where they started the year. While the equity markets have shown glimmers of hope of a strengthening economy, the increased numbers of reported coronavirus cases is putting markets back on edge so far in July. The next few weeks and months will most likely see a continued persistence of volatility across the board,” warns Michael Clark, managing director. “Plan sponsors will want to ensure that they are making strategic decisions now that will help them weather this volatility to protect against falling further behind and capitalizing on market upswings when they happen. That will necessitate looking at different investment tools and having consultants that are actively engaged in helping fiduciaries make timely decisions.”

NEPC’s Pension Funded Status Monitor shows the funded status of a total-return plan rose by around 0.4%. It says funded status posted a bigger jump for plans with higher interest rate hedges, including corporate bonds, what it calls liability-driven investing (LDI)-focused plans. The hypothetical NEPC frozen pension plans recorded a 1.3% increase in funded status for the quarter.

Legal & General Investment Management America (LGIMA) estimates that funding ratio levels for the typical plan with a traditional asset allocation increased over the second quarter, primarily due to a strong global asset rebound positively impacting plan assets. “The second quarter saw a substantial increase in equity returns, which was the main driver of the improvement in funded status for pension plans,” says Katie Launspach, senior solutions strategist at LGIMA. “Volatile times like this show the importance of decoupling risks that can impact pension plan funded status, such as interest rate and credit spread risk. Separating these risks can help plans design and implement a more appropriate LDI strategy. Hedging more interest rate risk through a completion framework and avoiding defaults and downgrades through active credit management are two ways that can help improve funded status outcomes in such volatile markets.”

Goldman Sachs Asset Management (GSAM) estimates that funding has increased by 2.1 percentage points to 80.5% on a quarter-to-quarter basis, due to tightened credit spreads and the Fed’s commitment to buy corporate bonds. GSAM foresees growth in the private equity market, as well as with distressed and structured assets. Additionally, following an LDI strategy, credit remains an attractive alternative to government bonds, which maintain historically low yield rates, it says.

Despite the turmoil in the markets, Mercer still sees opportunities for plan sponsors to transfer risk. “We continue to see extremely attractive pricing for annuity buyouts, and with the decrease in interest rates since the beginning of the year, lump sum windows may be attractive for many plans,” says Matt McDaniel, a partner in Mercer’s Wealth business.