Last year was a great year for pension funds, no doubt about it. But is trouble looming?
First, there’s the tapering of the Fed’s bond buying program.
“The big unknown is the effect of the stimulus on the equity market,” said Zorast Wadia, principal and consulting actuary for Milliman Inc. in New York. “A loss [in those markets] could offset gains” garnered from higher interest rates.
Second, is whether managers have learned the lessons delivered by two market crashes since the turn of the century. Pension fund managers often say one their priorities is reducing risk.
Although some have taken action to protect themselves from the sort of market fluctuations that wreaked havoc on the markets twice since the turn of the century, it’s not clear it will be enough.
Many plans have moved to a liability-driven investment strategy, which reduces the risk of being susceptible to changes in interest rates and inflation, often by using hedge funds, derivatives and swaps.
Nothing, of course, is certain when it comes to any investment strategy and if interest rates rise faster than the Fed intends, even the best-laid LDI plan might not work as intended.
“[Rising interest rates] could hurt plans,” Wadia said. “It depends how effective the LDI was.”
Still, they are likely better off than in the past.
“[Pension fund sponsors] have taken action so that we don’t look like we did” before previous bubbles, so “they [probably] won’t be hurt by any equity disruption, said Charles McKenzie, head of institutional solutions for Pyramis Global Advisors, a division of Fidelity investments company based in Smithfield, R.I.
Despite the concerns, there’s no denying that 2013 was a banner year after all the woes following the start of the Great Recession.
“Funded ratios went up, liabilities went down and all of a sudden, holy smokes,” McKenzie said.
Just how far corporate pension funds have come is reflected in the latest Milliman 100 Pension Fund Index, which found that the funding status of the plans measured was nearing 95 percent at the end of November.
Higher interest rates helped by driving up the discount rate, which is used to calculate long-term liabilities. Last year’s 90 basis points in rates even before the Fed made its announcement combined with record stock prices to leave pension funds the healthiest they’ve been since the recession began.
And as the funding status of a pension plan rises, a company reaps benefits to its bottom line because contributions to keep the system viable can be reduced or even eliminated.
For instance, 3M announced last month that its annual payments to its pension fund would drop from $500 billion to $200 billion or less for each of the next three years. The company said its U.S. retirement plan was 103 percent funded, but its foreign pension fund was not fully funded. The $300 billion to $400 billion reductions in contributions will be available to help grow the business.
The idea, McKenzie said, “is to make the pension plan as non-disruptive to the bottom line as possible.”
One way that pension plan sponsors do that is by derisking, either by shifting liabilities to an annuity purchased from an insurance company or offering lump sum payments to plan participants.
One factor that might cause companies to consider derisking is the rise in premiums that will be paid to the Pension Benefits Guaranty Corp. this year. The new premiums could add as much as 3 percent to the costs of running a plan and were part of the budget passed by Congress in December.
McKenzie said that the premium hikes coupled with rising life expectancy would add to the “factors that companies would look at to consider” whether to derisk retirement plans.
Fewer companies took such steps last year but that might change in 2014.
“I think we’re going to see more plan sponsors seriously consider it,” said Jonathan Waite, director, investment management advice, and chief actuary for institutional group of SEI. “When a plan is more fully funded, it costs less to derisk.”
As companies move their retirement benefits for new employees from defined benefits to defined contributions plans, shedding the liabilities and the risks associated with a legacy DB plan might have appeal.
Yet, while this might be a great time for companies to derisk, there’s a chance the window to do so might close. If, for instance, the markets drop and pension fund asset fall, the costs to derisk might be too high to make it practical.
Risk is at the forefront of concerns listed by midsize pension plan sponsors, according to a Pyramis survey.
The poll of 166 midsize U.S. corporations conducted in September and October found the top three concerns were risk management (31 percent), low return environment (29 percent) and volatility (24 percent).
“If I’m a pension plan sponsor that has decided defined contributions are going to be my plan for the future,” McKenizie said, “even if I’m fully funded I still have concerns [about the markets].”
Still, the survey found that the majority of plans intended to raise their risk profile in the next year or two with increased investments in emerging market equity (17 percent), global equity (16 percent), liquid alternatives (12 percent), and emerging market debt (10 percent). Ten percent said they planned to reduce allocations to U.S. equities.
In the end, the easing of the Fed’s bond buying program is “generally good for plan sponsors,” McKenzie said.
Waite of SEI sees it much the same way.
“My expectation would be for comfortable growth in 2014,” he said.