The Wall Street Journal noted recently that corporate pension plans have been piling into bonds to reduce funding volatility in their pension funds. But these moves, which are a function of liability-driven investing (LDI), are neither new nor progressing – at least not now. In fact, many plans are in a holding pattern, a waiting game.
LDI dates back more than a decade and accelerated after the financial crisis sent rates sharply lower – boosting the value of pension liabilities, which are discounted by high quality market interest rates. The value of fixed income assets tends to move in tandem with pension liabilities, so bonds – typically long investment grade corporate bonds – may help to mitigate risk to a plan’s funding ratio (of assets to liabilities). Equity returns tend to have low and unstable correlations to liability returns. Thus, in an LDI regime, plan sponsors will usually boost allocations to fixed income and cut stock holdings as their funding ratios improve.
But these “de-risking” strategies have largely paused or in some cases gone into reverse following last year’s deterioration of funding ratios. Despite strong equity market returns in 2014, funding ratios fell because plans’ liabilities grew faster – the result of lower interest rates and updated mortality tables that projected longer life spans. According to Milliman’s latest Pension Funding Study, last year the 100 largest defined benefit plan sponsors suffered an average 6% drop in funding ratios to 82%. De-risking (i.e., boosting exposure to bonds) has been put on hold as many plans evaluate whether to stay the course or increase stock allocations in hopes of capital gains and an eventual rise in interest rates.
A return to de-risking, in our opinion, is a matter of “when,” not “if.” We estimate corporate pension demand of $250 billion – $500 billion in long duration bonds over the next five to seven years. The trigger will be an improvement in plan funding, which could happen for three reasons:
- Discount rates (driven by long corporate bond yields) increase and liabilities fall in value.
- Return-seeking assets (e.g., equities and/or alternatives) appreciate materially.
- Plan sponsors inject more contributions into their plans.
It will be a combination of these reasons that will drive a material improvement in plan funding, with the “when” largely dictated by the timing of the first two. Until then, the waiting game goes on.