Hedging May Have Buffered DB Plan Losses in May

All firms that monitor defined benefit (DB) plan funded status reported a bad month for pensions in May.

River and Mercantile reports that discount rates fell more than 20 basis points, and equities lost in excess of 5%. “Almost all plan sponsors should see a notable drop in funded status unless they are heavily hedged,” its Retirement Update for June says.

According to Legal & General Investment Management America (LGIMA) there would be potential leverage benefits obtained through derivatives such as futures and swaps that would allow plans to gain market exposure without having to fully pay the cash cost up front. And, daily risk management ensures conservative capital requirements are met. Without leverage, $60 million in assets hedge $60 million in liabilities, but with leverage, $60 million in assets hedge $100 million in liabilities.

LGIMA estimates that the average plan’s funding ration fell 5% to 82.4% in May, primarily driven by negative equity performance and declines in Treasury yields which resulted in a decrease in the discount rate. LGIMA blames trade-wars in part for the negative equity performance and falling interest rates.

Brian Donohue, partner at October Three Consulting, says, “Pension finances got clobbered in May, due to falling stock markets and lower interest rates, giving back gains enjoyed earlier in the year.” Both model plans October Three tracks lost ground last month: Plan A lost 6% and is now down almost 2% for the year, while Plan B lost close to 2% and is now basically flat through the first five months of 2019. Plan A is a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, while Plan B is a largely retired plan (duration 9 at 5.5%) with a 20/80 allocation with a greater emphasis on corporate and long-duration bonds.

According to Northern Trust Asset Management (NTAM), corporate pension plans experienced a significant decline in May as the average funded ratio dropped from 90% to 86%. Negative returns in the equity market along with higher liabilities led to unfavorable results in funded ratios. Global equity market returns were down approximately 5.9% during the month. The average discount rate decreased from 3.51% to 3.27% during the month, leading to higher liabilities.

The aggregate funded ratio for U.S. corporate pension plans decreased by 4.0 percentage points, reversing April’s increase, to end the month of May at 85.6%, according to Wilshire Consulting. The monthly change in funding resulted from a 0.8% decrease in asset values and a 3.8% increase in liability values. The aggregate funded ratio is down 1.9% year-to-date, and down 4.5% over the trailing twelve months.

Ned McGuire, managing director and a member of the Investment Management & Research Group of Wilshire Consulting, says, “May’s 4.0 percentage point decrease in funded ratio is the second largest monthly decline since January 2015.”

According to Mercer, the estimated aggregate funding level of pension plans sponsored by S&P 1500 companies decreased by 5% in May to 85%. The S&P 500 index decreased 6.35% and the MSCI EAFE index decreased 4.66% in May. Typical discount rates for pension plans as measured by the Mercer Yield Curve decreased from 3.84% to 3.63%.

“Despite decreases in interest rates earlier this year, the equity market drove funded status higher. However, the trend changed dramatically during May as the funded status gains we saw since the beginning of the year were completely erased with both interest rates and equities moving in the wrong direction,” says Scott Jarboe, a partner in Mercer’s U.S. Wealth business. “The persistent volatility serves as a reminder that pension risk management is an on-going process and plan sponsors must be diligent to ensure they are well prepared to weather the storm.”