The secret to managing pension plan risk

Frank Salem, Senior Portfolio Manager | February 10, 2014

  • Historical overreliance on risk assets have made pension plans vulnerable
  • Why funded status is the best measure of a pension plan’s health
  • How can pension sponsors manage funded status volatility?

This past fall marked the one-year anniversary of the devastation to the New York area caused by Super Storm Sandy. Following the disaster, many who rebuilt also added safeguards, such as moving structures further from the beach and building higher and stronger foundations. With these added safeguards, the probability of losses in future storms will be diminished. Likewise, after going through several cycles of financial advances and setbacks, pension plan sponsors are beginning to build safeguards against losses in their pension plans. Funded status (the amount by which a pension plan’s assets exceed the plan’s projected benefit obligations) is the best measure of a pension plan’s health, and once a plan becomes underfunded, its financial position becomes more strained, it is required to increase contributions and financial statements are negatively impacted.

The chart shows periods when S&P 500 Index companies have been over funded and periods when there was a shortage of assets to cover expected payouts. There were two periods in the past when plans had surplus assets and due to subsequent market actions the surpluses were lost. The first decline was the dot.com crisis in the early 2000s and the second was the Great Recession of 2008. In both instances, asset allocation in plans favored equity and other risk assets that experienced significant declines in value. Simultaneously, the interest rate used to discount the liability fell, increasing the present value of future payouts. These experiences placed added stress on sponsors’ financial strength just when the economy was cyclically weakest. Additionally, with the new funding requirements and accounting rules enacted in 2006, a plan’s underfunding needs to be addressed more immediately and becomes more transparent to the public.

Salem

In 2013, a typical S&P 500 company pension plan’s funded status increased to an estimated 95%, the highest level since before the financial market collapse of 2008. Rising stock market valuations are estimated to have accounted for 40% of the improvement and higher interest rates contributed the remaining 60% of improvement. Any decline in stocks or a lower liability discount rate will reduce these gains. What does this mean? For plans with a historic asset allocation of 60% equities and 40% aggregate bonds, the volatility of the funded status is around 15% a year. In sharp stock market decline — two standard deviations — a plan could become under funded by 25% or more depending on the change in interest rates.

Changes in the present value of pension liabilities are driven primarily by changes in the interest rate used to discount future payouts. With the long duration of a pension plan’s liabilities, even small changes in interest rates can have a large impact on present value. When plan assets are not aligned with the liability the funded status will be highly volatile. While equity holdings and other risk assets are useful for underfunded plans to improve their funded status, they have little or no correlation to the liability discount rate and are an added source of risk to the plan’s funded status. The widespread improvement in funded status makes now an opportune time for pension plans to reduce risk.

Over the past 10 years, a growing number of pension sponsors have done just this, embarking on a process to build a better structure to manage volatility of funded status. The process improves the matching of fluctuations in plan assets and liabilities to better manage funded status volatility in future periods of market volatility. While this is certainly a step in the right direction, many sponsors have either not taken any measures or made too-modest modifications to their allocation strategy to meaningfully reduce pension plan volatility. Consequently, their plan’s funded status remains exposed to risk asset fluctuations and interest rate movements.

The first step to address funded status volatility is to quantify the level of variability between assets and liabilities in relation to changes in stock market valuations and interest rates. Every pension plan has a unique liability stream and asset mixes are highly variable from plan to plan. Once the volatility between asset and liability is quantified, the plan sponsor can better address risk management and the appropriate level of expected earnings.

In subsequent discussions, we will explore an approach to systematically reduce a plan’s funded status volatility and the benefits of a bond portfolio matched to a specific plan’s liability. Sponsors that move along a path to adopt these changes will strengthen their plan against losses from future market turbulence and reduce the financial risk to the sponsor.

 

Frank Salem

Senior Portfolio Manager
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