As interest rates rise and bond prices fall, companies are evaluating the effects on all aspects of their business—from their lines of credit to their pension plans. And although the drop in bond prices has lowered the value of assets in pension plans, the latest “Russell LDI update” points out that rising interest rates have had the opposite effect on plan liabilities. According to Bob Collie, chief research strategist for Americas international with Russell Investments, the reduction in liabilities has improved pension plans’ funded ratios, but some companies may have been too focused on the fall in asset values to notice the improvement.
“When corporations talk about the objectives of their pension plans, the objectives are based on asset versus liability, so net position,” says Collie. “But we find when it comes to month-to-month tracking or quarter-to-quarter reporting, those objectives may get set aside. Companies look at the fall in asset values and think that’s bad, but they may not the evaluate how their funding status moved.”
Russell Investments demonstrates the effects of recent market swings on plans’ funding using a pair of hypothetical pension plans. One is envisioned as an open plan in which 60 percent of assets are in the Russell Global Index and 40 percent are in the Barclays-Russell LDI 12-Year Index. The other is envisioned as a closed plan in which 40 percent of assets are in the Russell Global Index and 60 percent are in the Barclays-Russell LDI 8-Year Index. “By using a global index, we may have slightly more international exposure than the typical plan,” Collie says. “Any individual plan may differ, but we chose for our representative plans an asset mix that is simple to explain and broadly representative of where plans typically are.” Russell Investments projected liabilities in the open plan to have a 12-year duration, which is to say that the average (hypothetical) benefit payment is projected to be made in about 12 years, and projected an 8-year duration for the closed plan.
The company assumed that both plans had a funded ratio of 73 percent as of December 31, 2011, which was the median funded status on that date, according to an analysis of the 10-K filings of U.S.-listed corporations. Then Russell Investments ran both plans through its Standard Cash Flow Generator formula to calculate funding status. Figure 1 shows the results of this exercise: Plans’ funded ratio at the end of June was the highest it’s been in 18 months, and just in the first half of 2013, funded ratios rose 7.1 percentage points for the hypothetical open plan and 3.5 percentage points for the closed plan.
“That’s a timely reminder that the management of a pension plan is now at least as much about managing the exposures on the liability side as it is about managing the exposures on the asset side,” Collie says.