From the July-August 2009 issue of Treasury & Risk magazine

Pensions Hunker Down

Last year's market sell-off is encouraging corporate plan sponsors to lighten up on equities as they shy away from risk in general.

The magnitude of last year's sell-off in the financial markets has set in motion normally slow-moving corporate pension plans. Plan sponsors are starting to reshape the way plan assets are allocated and making changes to other longstanding practices, such as securities lending, a recent survey shows. "When you've lost a lot of money, there's clearly an incentive to de-risk and ensure you have more stability," says Goran Hagegard, a principal at financial services consultancy Greenwich Associates.

Certainly that assessment is true of corporate pension plans. The average funded status of the plans operated by companies in the S&P 500 index slid to 78.1% at the end of 2008, from 104.4% at the end of 2007. As a group, the plans hit a record level of under-funding of $308 billion at year-end 2008, after having been over-funded to the tune of $63 billion in 2007, according to Standard & Poor's. Companies that reported big hits to their plans last year include Verizon, which saw pension assets plunge 30.7% to $51.8 billion, and Supervalu, whose pension assets fell 25.2% to $6.6 billion.

In the wake of the carnage, a Greenwich Associates survey found that almost 80% of corporate plan sponsors cut their allocation to U.S. equities last year and almost 20% described that reduction as "significant." Roughly the same percentages of the 97 companies surveyed said they had increased or significantly increased their holdings of fixed-income securities. A separate survey by Callan Associates showed the average allocation to domestic equity stood at 38.4% at the end of 2008, down from 50.5% in 2003, while the average allocation to domestic fixed-income stood at 36.7%, up from 32.3% in 2003.

Pension plans had already taken a big hit when the dot.com bubble burst in 2001-2002. Since then consultants have been preaching the gospel of liability-driven investing (LDI), an approach that involves lowering a plan's risks by aligning its assets more closely with its liabilities, which are more similar to bonds than stocks.

As a practical matter, companies can take many different routes to implementing LDI, ranging from moving assets out of stocks and into bonds to extending the duration of their fixed-income holdings or using derivatives to increase their exposure to fixed-income. But from a plan sponsor's perspective, the path to lower risk is paved with lost opportunities, since riskier assets like stocks usually carry a higher expected return than less risky assets like bonds. And choosing the less risky path becomes particularly painful when pension plans are already short on funding.

"LDI can be a very expensive move. You have to lower your expected return," says Jay Kloepfer, director of the capital markets and alternative research group at investment consulting firm Callan Associates. Companies might have found it easier to adopt LDI when they were overfunded. With plans now facing funding shortfalls, lower expected returns are likely to mean the company has to boost its payments to the plan, he says. Greenwich Associates' Hagegard agrees. "If you do take the [allocation to] risky asset classes down, you'll run into a situation where you need more contributions from the company," he says.

Joe McDonald, a principal in the retirement practice at HR consultancy Hewitt Associates, expects a shift from risky into lower-risk assets to take place but over an extended period of time. He says many companies plan to start moving to less risky assets once they are fully funded, rather than doing it now, when the change would make it harder for them to improve their funded status. But he notes that this strategy didn't work that well over the past decade. After spending years recovering from the dot-com crash, companies were fully funded only briefly in 2007 before seeing their plans sink into the red again last year. "It probably is wiser to gradually take risk off the table versus taking one big step once you get to 100%," McDonald says.

Not surprisingly, the Greenwich survey also shows a renewed respect for cash, with 34% of corporate plans saying they increased the liquidity requirement for their portfolio last year and 4% saying they increased it significantly. The emphasis on liquidity reflects the awkward situation many plans found themselves last year, says Hagegard. "Equities had fallen so far you didn't really want to sell them. Your fixed-income portfolio just didn't trade. Your hedge fund-- you couldn't get your money out. Your private equity--they wanted money from you," he explains.

Plan sponsors are also more interested in passive management, according to the Greenwich survey, with 20% having shifted some assets from active to passive management. And companies are moving away from lending out the securities in their pension plan's portfolio to pick up a few extra basis points after some institutional investors lost money last year on such lending; part of the return from securities lending comes from investing the cash collateral the borrower puts up, and in last year's volatile markets, some cash collateral pools suffered losses. Almost half of plan sponsors say they are cutting back on securities lending.

Hewitt's McDonald notes that companies may be wary right now of implementing LDI by using derivatives to increase their exposure to fixed-income because events last year, like the bankruptcy of Lehman Brothers, reminded them of the counterparty risks involved in derivatives transactions. "What we would recommend is to get your equity exposure via an overlay and then move investments into the long-duration bond market, where there are attractive returns," McDonald says. "That's an emerging approach that makes more sense going forward."

As plan sponsors contemplate investing more of their assets in the bond market, they are wary of risk-free fixed-income instruments like U.S. Treasuries, which have already rallied significantly. They are interested in corporate bonds, given expectations that credit spreads will continue to tighten, McDonald says. "Even those who don't want to sell their equities because they're at a bottom would say they're seeking that value in the corporate bond."

Greenwich Associates' Hagegard cautions that plans' changes in asset allocation may not be permanent, especially given the pressure companies face to make up for shortfalls in plan funding. "We do not yet know if this is a short-term reaction, before [plan sponsors] take things back into more high-yielding, and more risky, assets," he adds.

Institutional investors regard the damage done to plan assets last year as the result of broken financial markets, rather than broken asset-allocation models, Hagegard says. "We want to continue refining those models and taking into account our appetite for risk, but there's no new paradigm on the horizon."

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