Solving pension funded status crisis by reducing pension riskAs participants in the financial markets watch the Fed like hawks, each wanting to be the first to discern when interest rates will rise, pension plan sponsors are grappling with a different challenge: How can a plan cost-effectively mitigate the effects of the low-interest-rate environment on its funded status without putting plan assets in too much jeopardy when the external environment changes?

To get a better handle on what pension plan managers should be doing today to prepare for the highly anticipated rate increases, Treasury & Risk spoke with Mike Moran, pension strategist with Goldman Sachs Asset Management.


T&R:  How has defined-benefit [DB] plans’ funded status changed in the first half of 2015?

Mike Moran:  Even though the markets are jumping up and down, the beginning of this year hasn’t been very exciting in the area of pension funded status. Our models show that corporate DB plans have an average funded status of about 84 percent. At the end of last year, that number was 83 percent. So not much has changed this year. But at the end of 2013, the average funded status was about 90 percent.

We’ve seen a decline of about 6 percentage points in the past 18 months, and that decline has been driven by two important factors. One is the low interest rate environment; the other is the wonderful news that we’re all living longer. When the Society of Actuaries [SOA] revised their mortality tables at the end of last year, the good news was that people are living longer, on average. The bad news for plan sponsors is that means pension plans need to pay benefits over a longer period of time than was previously baked into the numbers.


T&R:  How have pension plans been preparing for the likely rise in interest rates in the near future?

MM:  Well, most plan sponsors understand that a rising-rate environment would improve their funded levels. Liabilities are interest-rate–sensitive, so liabilities will fall more than fixed income asset values will fall when rates rise. In anticipation of a change in rates, many plan sponsors are putting in place glide paths, or ‘journey plans,’ which call for them to adjust asset allocation and investment strategy as funded levels change. Once interest rates rise, they will take action to lock in that higher funded status; they will increase allocations to fixed-income assets because long-duration fixed income will be the best match for their liabilities.

"When you create a custom liability benchmark, your own cash flows become the benchmark for gauging the performance of your asset manager." --Mike Moran, Goldman Sachs Asset ManagementAlong the same lines, many plan sponsors are re-evaluating their roster of asset managers. As they increase allocations to fixed income, they may consider adding another fixed-income manager. And some are also thinking about adjusting the benchmarks they use to evaluate fixed-income managers. We’ve seen plans that have increased their fixed-income allocations by a lot, then have moved from a publicly available benchmark like the Barclays Long Government/Credit Bond Index to a custom liability benchmark that is based on their plan’s own cash flow.


T&R:  What does moving to a custom benchmark entail?

MM:  The reason companies move to a custom liability benchmark is generally to make sure that their assets are moving in very tight correlation with their liabilities. When you create a custom liability benchmark, your own cash flows become the benchmark for gauging the performance of your asset manager. It requires very close coordination between your actuaries and your asset manager.


For more on pension de-risking, view the archived version of a recent T&R webcast: Why Now Is the Right Time to Transfer Pension Risk

This type of move typically doesn’t make sense for an organization until its fixed income allocation has reached a level of 60 to 70 percent. Many plans today are around 40 percent fixed income. They’re under-hedged, and moving to a custom liability benchmark probably does not make sense for them at this stage. But once you get to 60 or 70 percent fixed income, and you’re really trying to tighten up that hedge, a custom benchmark might start to make sense.

It’s also worth noting that many companies are probably going to change how they define success moving forward. If your goal is to make sure assets and liabilities move together, then the performance metrics you’re going to want to measure your asset manager against will no longer focus on whether your asset portfolio beats the selected benchmark, on whether it’s generating alpha. Instead, you’ll want to look at whether the portfolio is matching the benchmark as tightly as possible. So the time may be right to have a discussion as a plan sponsor about governance and about how you evaluate asset manager performance.


T&R:  Are you seeing any other trends in pension plan management related to the prospect of interest rates increasing?

"We have a glide path in place that says we should de-risk as funded status improves. Does that imply we should re-risk since funded status has fallen?" --Mike Moran, Goldman Sachs Asset ManagementMM:  There’s one other thing we haven’t talked about. We’re seeing more interest in unconstrained fixed-income strategies. As companies think about the return-generating side of their fixed-income allocation in the current climate, they want to be sure that their manager is nimble enough to navigate a rising-rate environment—if necessary, not only reducing the duration of the portfolio but possibly even going to short duration.


T&R:  Are companies making any changes in their pensions because of changes in money-market rules—in particular, the impending move to a floating NAV [net asset value]?

MM:  We’re seeing a lot of interest in capital preservation options, particularly among defined contribution plans. That’s not just because of money fund reform but also because of the low-rate environment. As rates start to rise, pensions will have three main tools for capital preservation: money market funds, stable value funds, and short-duration fixed income. Some plans are looking at revisiting stable value.


T&R:  Are there other broad trends that pension plan sponsors should be paying attention to in the second half of 2015?

MM:  When you look at pension plans’ current funded status of 84 percent—and there are certainly a number of plans that are funded below 80 percent—you see that we’re in an environment where plan sponsors need returns. Yet equity markets are trading at close to all-time highs, not only here in the United States but in many markets around the world. So we’re having a lot of conversations with clients about how to reduce the exposure to equities while still getting returns.


T&R:  Are companies continuing to de-risk as well?

MM:  De-risking continues to be the broad-based theme in the corporate DB space, but it’s worth noting that ‘de-risking’ means different things to different people. De-risking could mean increasing allocations to fixed income and extending the duration of fixed-income holdings to better match the plan’s liabilities. De-risking could mean closing a plan or freezing the plan so it’s not accruing more liabilities. De-risking could also involve risk transfer, such as transfer to a third-party insurance company to annuitize a portion of the participants. We continue to see a lot of activity in all of these areas. Another tool in the de-risking toolbox is outsourcing, where a plan sponsor comes to a third-party asset manager or consultant and wants help, not with transferring the risk off its books, but with managing the glide path and helping to make the right decisions on asset allocation and other aspects of plan management.

All these types of de-risking continue to be popular topics of conversation. We’ve also had some clients ask, ‘We have a glide path in place that says we should de-risk as funded status improves. Does that imply we should re-risk since funded status has fallen?’


For more on pension de-risking, view the archived version of a recent T&R webcast: Why Now Is the Right Time to Transfer Pension Risk

T&R:  Is re-risking something that a lot of companies are looking at?

MM:  It’s definitely the minority. We have some clients that say, ‘Absolutely not. The level of risk we have today is the most we can accept; de-risking is a one-way street.’ But we have others that have taken on what I would call a ‘re-risking’ position. Sometimes that entails taking money out of fixed income and moving it into equities. Other times, it’s not about changing asset allocations across asset classes, but about reducing the duration of fixed-income holdings in order to reduce the amount by which the plan’s fixed-income assets will fall when interest rates rise.


T&R:  What are the key considerations a plan sponsor should keep in mind when deciding whether to re-risk?

MM:  As with other decisions, materiality usually trumps other factors. If a company’s balance sheet has a very material exposure to the funded status of its pension plan, it has more of an incentive to consider the plan’s glide path as exclusively a risk management exercise. That company may elect not to re-risk. On the other hand, if the plan is immaterial and the plan sponsor can withstand volatility in the plan’s funded status, then the sponsor may be more likely to take on more risk in the plan. If that risk doesn’t work out in the short term, the impact on the company won’t be material.

Mike Moran, pension strategist, Goldman Sachs Asset ManagementA further reduction in plan funded status might be painful for some sponsors. If the plan’s deficit widens, the company might have to record larger liabilities on its balance sheet at the end of the fiscal year, with a corresponding reduction in book value. And an increase in the deficit gets reflected through the P&L via a convoluted and painful calculation. So to the extent you’re focused on GAAP earnings, if you see funded status drop a lot, you’re likely to record a higher pension expense in the following fiscal year. You might also have to pay higher variable-rate premiums to the Pension Benefit Guaranty Corp. (PBGC).

The mitigating factor in all of this is cash contribution requirements. If you think about the scenario we were discussing where the company re-risks, things don’t work out, and the funding gap widens, in a normal environment that scenario would imply the company would have to make higher contributions to its pension plan. But over the past few years, our friends in Washington have instituted several rounds of funding relief. That means even if a plan’s funded status declines, the company may not have to increase contributions in the near term. And I think for plans that have moved forward with re-risking, this funding relief has been part of their calculus.


T&R:  What about risk transfer? Does that remain a popular option?

MM:  Yes, we’re seeing more interest in risk transfer, for a variety of reasons. One is that the PBGC flat-rate premium, the dollar amount you pay per participant, is going notably higher. That has given some plan sponsors an incentive to transfer more of the risk so they can get out from under those premiums.

And then there are the SOA mortality tables. When calculating liability for GAAP accounting purposes, most plan sponsors have already adopted the mortality changes. But the changes haven’t been implemented for the purposes of lump sum calculations, and they may not go into effect until 2016 or 2017. So some plan sponsors are seeing an opportunity to transfer plan participants out today, via a lump sum offer, at the old mortality rates.

"If you're considering transferring risk to an annuity, you need to be looking at how you've positioned the assets in your plan's portfolio." --Mike Moran, Goldman Sachs Asset ManagementI think the new mortality tables have also incentivized some of the annuitization activity we see happening. Now, I don’t think the SOA has changed how insurance companies think about mortality. But suppose that before the SOA mortality table changes, a plan sponsor went to an insurance company wanting a price for annuitizing its retiree participants and the premium would have been, for example, 10 percent. So for every $100 in liability being transferred, the plan sponsor would pay the insurance company $110 for an annuity. Embedded in that premium was the insurance company’s understanding of mortality, which was more up-to-date than that of most corporate plan sponsors. Well, now that the Society of Actuaries changed their mortality tables, what was a $100 GAAP accounting liability before becomes a $105 liability. The insurance company will still charge $110 because nothing changed from their perspective, but the premium for annuitization will fall from $10 to $5, which makes the idea of annuitiziation more palatable for some plan sponsors.


T&R:  Are a lot of companies doing this?

MM:  We’re certainly seeing a lot of activity around lump-sum transfers, but we’re seeing increased activity in annuitization as well. And if you’re considering transferring risk to an annuity, you need to be looking at how you’ve positioned the assets in your plan’s portfolio so that if you decide to do an in-kind transfer, your assets are attractive to the insurance company and can help you on pricing.

There’s also, of course, the question of which participants to transfer. Retirees tend to be the population that is most cost-effective to annuitize, but if you just annuitize retirees, then that means there’s still going to be a plan left after the transaction—and the duration of that plan’s liabilities is going to look a lot different than the plan’s liabilities prior to the risk transfer. That means the plan’s glide path might look different and the asset allocation should look a lot different as well. There’s an important asset management component, even to annuitization decisions.