With stock market volatility currently high and trade war fears still in the air, consultants and asset managers are looking to 2019 as a year when corporate defined-benefit pension plans will need to review their risk assets, evaluate new investment strategies and focus more on matching their assets and liabilities.
“Looking forward to 2019, we think many plan sponsors will continue to explore risk-transfer activities, including annuity buyouts with insurers, lump-sum payments to participants, and full plan terminations, as well as reviewing their investment policies to ensure they are aligned with an evolving market environment,” according to Matt McDaniel, partner, leader of Mercer’s US Financial Strategy Group. “Equity market volatility seems to have returned, and interest rates are showing signs of rising from historic lows.” With that in mind, “plan sponsors need to evaluate the [situation] and make sure their risk exposures to both these factors are at an appropriate level,” he counseled.
While the Federal Reserve exerts a lot of control over short-term interest rates, pension funds are more concerned about long-term rates, due to the long-dated nature of their liabilities, McDaniel explained. “Recent rate hikes by the Fed have served to flatten the yield curve, with long-term rates not necessarily increasing,” he noted. “Rising discount rates reduce pension liabilities, so many plan sponsors are hoping rates will rise. But while the Fed actions increased rates at the short end of the curve, that did not do much to help pension liabilities, which are determined based on long-term rates,” he added.
Dan Kutliroff, head of OCIO Business Strategy at Northern Trust Asset Management, noted that during the first quarter of 2019, “we will be able to see how much cash the companies put into their pension funds [in 2018], which helped improve the funded status of the plans.” In 2018, many plan sponsors accelerated plan contributions before the tax reforms in the Tax Cuts and Jobs Act of 2017 took affect, which for most corporate pension plans was Sep. 15, 2018. With the old rates, the plans got a 35% deduction when making a contribution to the pension fund, while the new tax rate deduction is only 21%. (see related article)
With the additional cash that companies injected into their plans in 2018, “we expect to see improvements in their funded status, with companies more focused on matching their assets and liabilities,” Kutliroff said. As the funded status improves, plans will try to bank these improvements by investing in assets like long duration bonds that behave similarly to plan liabilities. At lower funded ratios, say 80% funded, they will want to earn their way out of that deficit, through equity and other return-generating assets. As their funded status improves, they don’t have to earn as much, and will be more focused on managing the volatility which can be accomplished by matching the plan liabilities with similarly-behaving bonds, Kutliroff explained.
De-risking the plan
Jay Kloepfer, head of capital markets research at Callan, observed that while the increase in funds going into these plans did not decrease liabilities, “these additional funds increase the assets held relative to the liabilities.” To the extent a plan had less assets than liabilities, the additional assets contributed reduced the amount by which the liability was unfunded and in that way they improve the funded status, he explained. “By making a contribution now, the plans reduced what would need to be contributed in the future.”
These moves are also part of plans’ risk-planning strategies. “If you put a lot of money in, you also probably de-risked the plan. So, the potential to lose it in the fourth quarter would have been different from an average that someone calculates,” he noted.
“The biggest toggle switch for a corporate plan is how much to have in growth assets, and how much in lability hedging assets,” Kloepfer noted. “If they put a bunch of money in the plan, chances are they have taken some growth assets off the table and perhaps extended the duration on fixed income to make sure it has a better match to the interest-rate sensitivities and their liabilities,” he said.
“Once the data becomes available, during the first quarter, we will be able to see how much cash companies put into their pension funds to help the funded status of plans,” Kutliroff noted. “With that, we might expect to see more companies shift more of their assets into long-duration fixed assets to match their assets with their plan liabilities.”
Potential for growth in the market
Looking ahead, Northern Trust expects to see continued growth in the equity markets. “We think the fundamentals of the economy are still solid. We don’t think the growth will be as much as it was, and some of the stimulus from tax reform and regulatory changes will recede a bit, but we think some of the fundamentals will still be supportive,” Kutliroff said.
The asset manager is expecting to see continued economic growth. “Interest rates won’t rise much from here,” he said. “As far as the recent volatility in equites, there is a lot of uncertainty around the trade war. There was a little bit of decline in some earnings releases across some sectors, and some uncertainty coming out from the Fed about what they will do with the monetary policy—if they will continue to raise rates. But we believe markets overreacted to these concerns in the fourth quarter, opening up an opportunity for risk taking in equity markets—especially if the Fed slows its normalization process and growth stabilizes at a lower level, as we expect,” Kutliroff said.
Callan’s Kloepfer noted that many of consultant’s clients were already well prepared for the recent market downturn. According to Kloepfer, they already felt that “the economic expansion was getting a little long in the tooth, and were asking us, ‘Are we going into a downturn, and should we do something about it?’” Callan’s response: “We don’t time the market, so we preach discipline.”
Callan also has been advising clients to “evaluate where you are supposed to be relative to your own long-turn plan, and if you are out of whack, rebalance.” Kloepfer added: “Make sure you are in position, because the worst time to adjust your portfolio is in the middle of a crisis, so you need to set your portfolio to handle the up and downs of the market.”
Going forward, Callan is advising its clients to sit tight. “When you have a down market, stick to what you are doing. That is what we are preaching.” The consultant likes to ask its clients: “If you think you have too much risk in your portfolio, what can you do about it? Most people are afraid of the stock market going down, so the way you can deal with that is to have less stock, but then people are afraid of losing out on returns,” he explained.
Of course, “there are other strategies, but they require more thought, care and deliberation, and that is what we are doing with clients. Don’t let the last quarter move your long-term expectation,” Kloepfer said.
“Overall, people have been expecting some kind of downturn, and there are lots of corporate plans that have taken a lot of steps to de-risk their portfolios. They put more money in, or close the plan to new participants. There are many who are hanging onto a riskier portfolio, so they can get better returns, which helps the financials of the company,” Kloepfer said.