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

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

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

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.  

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

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

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