Key themes for U.S. corporate pension plans in 2022

Feb 1, 2022

Beyond fully funded

Corporate pension plans have had an incredible year, with funded ratios up +11.1% as of December 31, 2021 according to BlackRock’s U.S. Pension Funding Update. Following a +2.7% funded ratio gain in 2020 (including a +13.8% rebound from March 2020 lows), the average plan is now 99.3% funded on a PBO basis as shown below – the highest level since the 2008/09 financial crisis and well within sight of being fully funded.

Average PBO funded ratio up +11.1% in 2021 (not including contributions)

Exhibit 1 image

Source: BlackRock U.S. Pension Funding Update

In this paper, our fourth annual corporate pension themes publication, we encourage all U.S. corporate plans to begin thinking beyond fully funded across four dimensions:

  • Glidepath design: Fully funded does not mean fully de-risked
  • Portfolio construction: Asset classes for a de-risked portfolio
  • Implementation: The ubiquitous importance of daily monitoring, technology, and expanding the implementation toolkit
  • End-game solutions: Forward planning is critical

We also provide an update on a variety of plan sponsor-driven initiatives that we have touched on in prior themes publications such as closing or freezing the plan, making voluntary contributions, borrowing to fund at low yields, and seizing the sustainability opportunity which may further help progress toward funded ratio goals.

Glidepath design: fully funded does not mean fully de-risked

Being 100% funded on a PBO basis typically does not mean the asset allocation is fully de-risked with 100% of the assets in a liability driven investment (“LDI”) program. There are two main reasons why this is the case:

  • The ‘end-state’ PBO funded ratio target is usually above 100%, at say 105% or higher to account for potential mismatches in actuarial assumptions vs actual experience (e.g. demographics, mortality, wages, lump-sum take rates, and plan expenses), disconnects in asset performance vs liabilities where the latter is not subject to downgrade or default risk , and potential premiums in the event of a future pension risk transfer (“PRT”) to an insurance company; and
  • Plans at 100% funded, even frozen plans with no future benefit accruals, often have liability growth rates or ‘hurdle rates’ which exceed the return available from a 100% LDI portfolio (as proxied by U.S. Long Credit bonds) which would result in a funded ratio decline over time.

Fully funded does not mean fully de-risked, particularly if the plan is still accruing benefits and/or the sponsor is not contributing

Hurdle rates are still well above the expected return from long bonds at 100% PBO funded

Hurdle rates return

Source: BlackRock. Hurdle rates reflect the required asset return to maintain 100% PBO funded based on approximate assumptions for participant count, liability cash flow profile, liability yield, service cost, PBGC premia and contributions. Numbers may not add due to rounding. Based on BlackRock’s Q3 2021 Capital Market Assumptions. Expected risk and expected returns are calculated using Aladdin Risk Model and are based on BlackRock’s capital market assumptions. Expected risk and return estimates are subject to uncertainty and error. Expected risk and returns for each asset class can be conditional on economic scenarios; in the event a particular scenario comes to pass, actual risk and returns could be significantly higher or lower than forecasted.

A material growth allocation is still required for most plans at 100% PBO funded

Frozen plan glidepath vs accruing plan glidepath

Source: BlackRock, for illustrative purposes only. Also see https://www.blackrock.com/institutions/en-us/insights/investment-actions/de-risking-glidepaths.

Another potential argument to keep some growth assets in the portfolio for fully funded plans is the diminishing marginal benefit one gets from a surplus risk perspective when LDI assets get beyond around 75% of total plan assets, relative to the benefits realized at earlier points on the glidepath. Specifically, when moving from 75% in LDI to 90% in LDI (and 25% in growth assets to 10% in growth assets) we find that expected surplus risk for a frozen plan only declines 0.7% from 3.4% to 2.7%, whereas the expected return of the portfolio declines by 0.8%, from 3.7% to 2.9%. In other words, the expected surplus risk benefit is arguably small, relative to the give up in return, at the final glidepath step. At earlier steps on the glidepath, implementing an LDI program tends to result in materially higher surplus risk reduction per unit of return.

From the sponsor’s perspective, a case can potentially be made to continue holding growth assets in an overfunded plan to generate pension income and thus improve non-operating earnings, or to generate a surplus for other uses (e.g. fund retiree medical expenses1, facilitate mergers and acquisitions2). However, we would caution investment decision makers that the ERISA fiduciary responsibility to focus on preserving benefits remains the ultimate priority when designing investment strategies for DB plans and that eventually the plan will become well-funded enough that a 90% or higher LDI allocation is warranted. We also encourage sponsors to consider the impact of “trapped surplus” in the plan, in particular the stringent rules and potential tax penalties3 if the sponsor seeks to revert surplus plan assets back to itself.  

What investment themes do you expect to emerge for corporate plans as we head into year end and 2022?

Average funded ratios are now in the low to mid-90’s and many sponsors will now start to think about “end-game” strategies if they haven’t already. This decision often boils down to ‘hibernating’ the plan by keeping the assets and liabilities on the balance sheet in a very low risk liability matched strategy and just paying down benefits over time, or to ‘transfer risk’ to an insurance company. Our research suggests that if the plan is not overly burdensome to debt ratios or other financial metrics, then ‘hibernating’ the plan is often the lower cost solution. ‘Risk transfer’ pricing continues to get more competitive, but the cost of executing those transactions, including actuarial / advisory fees, and transaction costs makes retaining the assets and liabilities on the balance sheet an attractive option.

The majority of corporate pension liabilities are “legacy” benefits, which are likely to accelerate the trend towards OCIO: Around 2/3rds of corporate pension liabilities are “legacy” benefits meaning they are benefits being paid to people that have left their employer or already retired. As asset allocation strategies move away from seeking return, towards liability matching strategies – which arguably are more engineering exercises – we expect this will accelerate the trend towards OCIO. Put simply, companies are less willing to commit internal resources where solutions can often be managed by a delegated provider more efficiently and at a lower cost.

With very tight credit spreads, there has been increasing discussion about whether clients should moderate their investment grade bond exposure. This can be achieved either through diversification in the growth portfolio, or for larger plans, to incorporate multi-sector or private credit strategies that have strong relationships to liabilities. BlackRock’s LDI team has done a lot of work in this area.

Seizing the sustainability opportunity. We believe corporate plans should start more explicitly considering and measuring the impacts of climate change and ESG on their portfolios. Examples of ways this might be done include:
Incorporation of “climate awareness” in capital market assumptions
Replacement of broad market index exposures with ESG aware index exposures to take advantage of their greater resilience in severe market downturns
Incorporation of ESG monitoring into regular reporting
Consideration of how investment managers are applying ESG principles when implementing their portfolios.

Martin Jaugietis, Co-head of Americas Pensions within BlackRock’s Multi-Asset Strategies and Solutions (MASS), discusses the themes we expect to emerge for corporate pensions in 2022.

Portfolio construction: Asset classes for a de-risked portfolio

As pension plans de-risk, it is likely that an increasing proportion of the total $3.7 trillion in DB assets will be invested in investment grade corporate bonds to match the interest rate and spread risk in liabilities. Indeed, we calculate that U.S. DB plans already own approximately 19% all investment grade U.S. Corporate bonds in existence 5. Bond supply over the past 10 years has largely met demand with the investment grade U.S. corporate bond market growing from $2.8 trillion in 2011 to $6.2 trillion in 2021 according to Bloomberg data, but to the extent rising interest rates and higher leverage ratios start to reduce the speed of corporate bond issuance at the same time LDI allocations for DB plans are growing, issuer and sector concentration in this asset class may become a greater concern. Going forward it may be necessary to look for other asset classes that can keep up with liability growth with marginal impacts on surplus risk.

We continue to believe that not all diversifying assets are created equal when considered in liability-relative terms. For example, in last years’ pension themes we highlighted that commodities are commonly considered a sound diversifying asset class in asset-only terms, but are one of the least effective in preserving funded ratios in the worst environments for DB plans – specifically when equities decline at the same time as rates decline. Unfortunately, Q1 2020 was a case-in-point where broad commodity exposures, as measured by the S&P GSCI index, dropped -42% compared to a decline in Russell 1000 Large Cap equities of -21% at the same time rates declined. In other words, commodities did not provide the diversifying protection to funded ratios when it was needed most. The need for downside protection to funded ratios becomes even more acute for well-funded plans.

Instead, we prefer diversifying assets – either in the LDI portfolio or the growth portfolio – that have interest rate sensitive characteristics similar to pension liabilities. Some may still suffer low or negative returns if equities sell off and rates decline, but not as sharply from a funded ratio perspective due to a positive exposure to the rates factor. Examples include real estate, multi-sector fixed income, securitized debt, high yield, emerging market debt, and infrastructure. Private credit may also be attractive for less well funded plans that do not have immediate intention to engage in a PRT transaction or to terminate. As shown in the left panel below, investment grade corporate bond spreads are near historic lows. This may increase the urgency for plans to tilt away from these assets in 2022, and towards a broader fixed income universe such as the one shown in the right panel below for at least part of their portfolio.

Investment grade corporate bond spreads are near historic lows, well-funded plans with high LDI allocations might consider a broader fixed income universe

Frozen plan glidepath vs accruing plan glidepath

Source: Bloomberg, BlackRock as of 12/16/2021. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index.

Implementation: Daily monitoring, technology, and toolkit expansion

As investment strategies for well-funded plans evolve from a total return “set-and-forget” approach to a dynamic LDI approach, monitoring funded ratios and key risk exposures such as interest rate hedge ratios using real-time data and flexible technology becomes increasingly critical for success. As benefits are paid, the duration of a typical closed or frozen plan declines requiring evolving LDI exposures. As shown in the left panel below, we believe capital efficient instruments still have an important role in these programs enabling plans to target specific interest rate and credit spread hedge ratios.

To the extent some plans seek to evolve their credit exposures dynamically, the right panel below demonstrates that adding ETFs to the LDI toolkit can improve liquidity and materially lower transaction costs. For example, when comparing the transaction costs in March 2020 of two commonly used fixed income ETFs to the transaction costs of an equivalent basket of physical bonds, the bid/ask spread of LQD to physical investment grade credit was 3bps vs 57bps and the bid/ask spread of HYG to physical high yield bonds was 2bps vs 147bps. In other words, investors that did not use fixed income ETFs to implement tilts in March 2020 may have eliminated a material amount of the gain they anticipated when bond spreads were high because they paid such high transaction costs to increase or adjust their exposure.

Capital efficient instruments allow plans to target specific hedge ratios, adding fixed income ETFs to the implementation toolkit can lower transaction costs

Exhibit 4 images

Source (bottom): Bloomberg. BlackRock. High Yield is represented by iShares iBoxx $ High Yield Corporate Bond ETF (HYG), Investment Grade Corporate is represented by iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). We selected HYG and LQD ETFs for illustrative purposes, as these are the most commonly used instruments for credit allocations. See also:
https://www.blackrock.com/us/individual/literature/whitepaper/fixed-income-etf-institutional-investor-adoption-en-us.pdf.

End-game solutions: Forward planning is critical

With the average PBO funded ratio for corporate plans above 99%, we anticipate many sponsors will weigh the decision of keeping the plan on the balance sheet in a very low risk liability-matched portfolio, or seek to reduce or eliminate the plan from the balance sheet through PRT. Data from LIMRA indicates that around $35bn of pension liabilities were transferred in 2021 making it a record year for U.S. PRT activity, but this was less than 1% of total DB liabilities meaning we believe it is still early days in the trend towards PRT.

The most common approach to PRT is a partial risk transfer of retiree liabilities, and pricing for these transactions is becoming increasingly more competitive with some deals priced below par (i.e. less than 100% premium vs PBO liability). However, our experience is these transactions can take a year or two to successfully implement. From an investment perspective, there is important planning work required to get the fixed income portfolio “insurance ready and as shown below, we estimate plans can save up to 98bps by transitioning assets-in-kind (rather than selling bonds and transitioning cash) to the insurance company. If there are remaining pension liabilities on the balance sheet post PRT, it is likely these will have a materially different risk profile requiring a new asset allocation policy. We believe that forward planning is critical for success in any end-game solution.

Estimated net savings (bps) for PRT up to 98bps with assets in kind

Exhibit 5 image

Source: BlackRock, Methodology: bid-ask spread is the equal-weighted average of 1 minus the ratio of the IDC Ask price and IDC Bid price (for each security) in the Bloomberg Long Corporate Index. IDC is the security pricing vendor that is most commonly referenced in pension risk transfer transactions. The above hypothetical performance is shown for informational purposes only. It is not meant to represent actual returns of, or meant to be a prediction or projection of, any fund or portfolio. It is provided to illustrate the impact of bid-ask spreads on insurer AIK discounts. No representation is made that a client account will achieve results similar to those shown, and performance of actual client accounts may vary significantly from the hypothetical results.

Download the full report on key themes for corporate pensions
We share our views on the issues that corporate pensions should focus on in 2022, including thinking beyond fully funded across four dimensions: glidepath design, portfolio construction, implementation, and end-game solutions.
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