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Jared B. Gross
The ebb and flow of the tides may seem a fitting metaphor to those in the pension world who have witnessed the rise and fall of plan funding over the past two decades. Plan sponsors have patiently borne the costs and risks of funding at the low ebb, waiting for the right combination of asset returns and higher interest rates to return. The course has been known for a long time: toward a de-risked future with less equity exposure and more liability-matching bonds. All that remained was to wait for the tide to rise.
From the recent cyclical low in early 2012, plan funding has staged an incredible comeback. Exceptionally strong equity returns have increased the value of many plan asset portfolios, while higher interest rates have reduced the present value of liabilities. In a recent report dated 9 January, economic forecasting firm ISI estimated that over the course of 2013 S&P 500 companies improved their collective funding ratio to 93% from 78%, an increase of more than $300 billion! Fully one quarter of S&P 500 plans are overfunded, and many of the rest are within sight of that once-distant goal. The tide has risen.
There are many ways to de-risk In broad terms, the de-risking of a pension plan is straightforward: Reduce the volatility of assets and shift the portfolio to duration-matched bonds that move in tandem with liabilities. Eventually, this is designed to remove the major sources of volatility in funded status while maintaining a portfolio with sufficient return potential and liquidity to make good on benefits as they come due.
Within this broad framework, however, there are many ways to proceed, some of which may be more suitable to the current environment. Simply put, although this feels like a very good time to take some equity risk off the table, we recognize that moving wholesale into long-duration bonds with rates low, the economy strengthening and the Fed beginning to taper is not for the faint of heart.
The situation may call for consideration of more subtle forms of risk reduction that focus on lowering asset volatility – and equity risk in particular – as a temporary substitute for the more complete de-risking typically offered by long-term bonds. Although we believe a move into long-duration bonds should eventually take place, making use of other strategies that are designed to reduce the volatility of equity portfolios or seek a greater degree of capital preservation in a rising rate environment could allow a plan the opportunity to lock in recent gains in plan funding. Figure 1 lays out several options that plans should consider:
Taking each of these options in turn, what are the key potential benefits and risks? To summarize briefly:
Time to set sail With improved plan funding comes the opportunity to de-risk, in hopes of putting a pension plan on a more stable footing and reducing the plan sponsor’s exposure to future volatility in earnings, balance-sheet risk and cash contributions. For plan participants, a well-funded and de-risked plan offers greater confidence with respect to the ultimate payment of full benefits. And while the temptation remains to stick with the strategy that has worked so well recently – holding on to equities and postponing a move to hedge liabilities – it serves to remember the sailor left ashore: Just as the rising tide will eventually turn, markets will not forever present so favorable an opportunity to shed risk.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk.Equities may decline in value due to both real and perceived general market, economic and industry conditions. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Dividends are not guaranteed and are subject to change and/or elimination. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Private equity and hedge fund strategies involve a high degree of risk and prospective investors are advised that these strategies are suitable only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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