Human Capital & Careers

Pension Plans: Why Safer Isn’t Catching On

Experts say many companies are dragging their feet on liability-driven investment strategies in hopes of taking advantage of current market conditi...
Alix StuartAugust 13, 2010

Ever since Congress passed the Pension Protection Act four years ago this month, corporate pension-plan sponsors have been slowly but surely moving toward less-risky asset allocations in order to maintain compliance with the law’s stringent funding requirements. For many, that has meant pursuing a liability-driven investment (LDI) strategy, using long-term bonds or a series of swaps in order to make the duration of assets match up with the expected maturation of liabilities.

The biggest drawback to such an approach is that it generally caps upside along with volatility, a sacrifice some companies were glad to make while equity markets were on a roller-coaster ride. In rocky 2008, for example, users of an LDI strategy could have seen a small gain, while those with a more-traditional allocation would have seen a nearly 25% loss, according to hypothetical portfolios constructed by Towers Watson.

In the past year or so, however, experts say they have seen companies becoming more reluctant to press forward with LDI strategies, for a variety of reasons.

For one, the equity markets’ relatively strong performance has created a siren call for plan sponsors that previously saw big losses. “Companies that are underfunded are more likely to stay with equities in hopes of investing their way out” of the situation, assuming they’re not in such poor condition that they can’t afford to take the risk, says John Ehrhardt, a principal with Milliman and author of its annual pension funding survey.

Milliman’s study this year (based on last year’s 10-Ks) hints at this. In 2009 pension equity allocations increased slightly, from an average of 44% to 46%, after several years of sharp declines. Some companies even made big increases in the category. Baxter International, whose pension plan was about 71% funded at the end of last year, boosted its equity allocation up to 69%, from 50% the year before, according to Milliman data.

Others are looking at trends in the bond market. “A substantial number of the people we talk to about implementing LDI strategies are concerned about interest rates going higher,” which would potentially make bond prices more attractive in the future than now, says Thomas Meyers, head of North American distribution at Chicago-based pension investment adviser Legal & General Investment Management America (LGIMA). “A smaller percentage are thoughtful about the general level of credit spreads,” which could affect future bond durations, he adds.

Asset Allocations

At some companies, the picture is even more nuanced. Bob Hunkeler, vice president of investments at International Paper, says his company has been steadily lowering its equity exposure, from 62% of its pension portfolio to 43% currently, with some increase in alternative investments as well as in fixed income. However, the company also unwound its LDI strategy, which largely involved hedging its liabilities through swaps, in the fall of 2008 as swap rates began to diverge from the corporate bond discount rates that factor into the calculation of pension liabilities. “We’re looking for those two rates to come back together before we get back in,” he says.

Overall, says Aaron Meder, head of LGIMA’s U.S. pension solutions unit, the firm sees about half of the companies it works with treading water in the near term, even if they have a long-term goal of moving into bonds.

Trying to time the market, however, may or may not be well advised. Edwin Koopmans, treasury director for Sara Lee, believes a company should stick to its strategy, regardless of what the markets are doing. Sara Lee, an LGIMA client, began taking a liability-driven approach with its U.S. pension assets in the beginning of 2008, after proving the concept in a U.K. business it had acquired.

The first step was moving from a 65% equities/35% fixed-income mix to a 50%/50% mix (for this purpose, Sara Lee included risky alternative assets such as real estate and commodities in its equity category), while lengthening bond durations at the same time. As of this year, including a $200 million voluntary cash contribution to the $1.45 billion pension fund that was heavily directed toward fixed income, 75% of the fund’s assets now sit in fixed income, and only about 25% are in equities. The plan is currently 85% funded.

“We didn’t suffer from the equity-market volatility as much as other companies, and on the other side of the coin, didn’t see the same kind of recuperation as markets started to recover,” says Koopmans. “But that’s what we’re aiming for: reduced volatility in the funded status.”

Some experts agree with him. “We’re going to continue to see volatility in the markets, so we think having a proactive plan versus a reactive plan is better,” says Chris Wittemann, a senior investment consultant for pension plans with Towers Watson.

The future of pension-accounting standards would seem to point to lower equity allocations as well. The current exposure draft released by the International Accounting Standards Board, which is expected to have a big influence on future U.S. rules, would eliminate one of the biggest current incentives for holding equities. That’s because the proposed rule does not factor the expected return-on-assets assumption into pension-expense calculations, notes a recent Towers Watson white paper, effectively decoupling asset allocation and pension expense in any given year. Actual gains or losses from investments would also be moved out of earnings-per-share calculations and into the “other comprehensive income” section.

While accounting measures don’t affect funding requirements, they still “potentially have big implications on investment strategy,” says Wittemann.

Still, ahead of those new rules coming to bear on U.S. companies, it’s almost as hard to justify leaving money on the table as it is to swallow big losses, say others. “From a purely theoretical point of view, a pension plan has a very long time horizon,” says Ehrhardt. “But you have to mix that with the fact you’re dealing with a corporation” that faces short-term pressures on earnings and EPS, he adds.