Assessing the impact of recent market volatility on U.S. corporate pensions

Alison MacArtney| Calvin Yu, CFA |May 4, 2020

Q1 2020 market impact

As anxiety about COVID-19 escalated toward the end of the first quarter of 2020, global equity markets fell precipitously, rates across the US Treasury yield curve fell below 1%, and credit spreads widened to levels not seen since the Global Financial Crisis. While the impact of the outbreak may be sharper and deeper than many originally anticipated, we do not see this as a repeat of 2008. The broader economy was on firmer footing before the outbreak, and the monetary and fiscal policy responses have been massive and swift.

Amid the volatility, we must be mindful of how market fluctuations create imbalances relative to a corporate pension plan’s strategic asset allocation (SAA) and liability-hedging objectives. Given the magnitude of the decline and the elevated transaction costs involved in rebalancing, investment decisions made during these times may be some of the most critical in shaping the portfolio’s path forward. This analysis reviews the Q1 2020 market impact on plan funded status as well as the level of active risk relative to the original asset allocation from different rebalancing practices. To help formulate the path forward, we analyze potential funded status paths based on three illustrative market recovery scenarios:

An L-shaped recovery of asset values
Where COVID-19 continues its global spread, pushing a potential market recovery beyond the next three years
A U-shaped recovery of asset values
Where markets drawdown further over the next six months and gradually recover over the next 24-36 months
A V-shaped recovery of asset values
Where markets recover over the next 6-12 months

As of December 31 2019, we estimate that the average corporate pension plan was approximately 89% funded, with an average asset allocation of 41% equities, 46% fixed income, 11% alternatives and 2% cash1 . However, market volatility during the first quarter of 2020 may have severely impacted those figures. 

To gauge the impact, we conducted an analysis based on the average allocation of corporate plans, assuming the fixed income portfolio was invested in long government/credit exposures. This modeling results in approximately 50% interest rate hedging relative to the liability on a dollar-duration basis. Additionally, as many plans have implemented custom liability-driven investment (“LDI”) strategies in recent years, we modeled another allocation where the fixed income portfolio was invested in a custom LDI strategy that targets higher interest rate hedge ratios. We assumed the custom LDI strategy invested approximately half of the fixed income portfolio in long credit, while the remainder utilized interest-rate-linked instruments to achieve 85% interest rate hedging relative to the liability on a dollar-duration basis.

While the experience of individual plans varied widely depending on SAAs, plan statuses, hedging programs, and contribution policies, our scenario analysis estimates that plans that hedged more interest rate risk did better, and a few well-funded plans with most of their assets in LDI strategies saw funded status improve. Our analysis indicated the following findings2 :

  • The average plan experienced a 9% decline in funded status, representing a one standard deviation movement based on expected funded status volatility.
  • Plans with custom LDI allocations fared considerably better. They experienced only a 2% decline in funded status, representing a 0.3 standard deviation movement based on expected funded status volatility (See the A historic selloff chart).
  • The average US company saw its pension liabilities jump to 57% of market cap by the end of March, more than double the amount at the beginning of the year. (See the Growth in pension materiality chart). Liabilities fell modestly as falling rates were offset by widening spreads, and market caps shrank in the equity sell-off.

A historic selloff

Estimated impact of market stresses on average and custom LDI portfolios

Scenario analysis – average allocation
Scenario analysis – custom LDI allocation

Source: BlackRock, April 2020. Risk: 84% confidence interval, 231 constant weighted monthly observations, 1yr horizon, ending 3/31/20; see “Risk Factor Glossary” in the Appendix for additional risk details and “US Corporate Pension Plan Allocations and Benchmark Mapping” in the Appendix for details regarding the indexes used to represent each asset class.  Historical scenarios simulate each plan’s current portfolio through historical time periods.  Hypothetical scenarios simulate each plan’s current portfolio through hypothetical large market shocks and geopolitical stresses, with implied shocks. The performance shown is hypothetical, does not represent the performance of any existing portfolio, and does not reflect fees and expenses; if fees and expenses were included, the performance would be lower. It is not possible to invest directly in an unmanaged index. There is no guarantee that any portfolio will perform in this manner under similar scenarios going forward.  Please refer to  “Stress Test Scenarios Methodology, Assumptions and Limitations” in the Appendix for additional information. Liability is modeled with generic cash flows discounted at the Bank of America Merrill Lynch US AAA-A Discount Curve. The assumed funded ratio is sourced from the Milliman Corporate Pension Funding Study on the 100 largest corporate defined benefit pension plan sponsors as of 12/31/2019. Change in funded status assumes assets and liabilities are shocked by amount of stress PnL.

Growth in pension materiality

Average projected benefit obligation relative to market capitalization (%)

Average PBO relative to market capitalization

Source: BlackRock, April 2020. Based on 2019 10-k filings of 864 US companies with DB plans in the Russell 3000 Index. PBO liability returns based on the historical levels of the Bank of America Merrill Lynch Mature US Pension Plan AAA-A Index from 1/1/2020 to 3/31/2020. Past performance is not indicative of future results.

Additionally, given the speed at which the recent market volatility transpired, asset allocations have likely drifted significantly for those plans that have not rebalanced. For the average allocation, this has resulted in overweight positions to fixed income and cash/cash equivalents of approximately 7%, and corresponding underweight positions to equities and alternatives. Meanwhile, plans with custom LDI allocations may be approximately 10% overweight in fixed income, and underweight an equivalent amount in equities and alternatives. The Massive drift chart highlights how far away from benchmarks plans may find themselves. As this simulated analysis is based on economic proxies of underlying investments, actual results for private market investments may take several quarters to flow through to reported returns and the impact to investors may differ. For plans utilizing custom LDI strategies, rebalancing frequency, capital efficiency and instrument flexibility could have led to vastly different outcomes as transaction costs, even in the most typically liquid securities, spiked amid the volatility. For example, 30-year Treasury bond bid-ask spreads rose from 0.2 - 0.5 basis points in early March to 6 - 7 basis points on March 20.3 Investment grade credit bid-ask spreads rose from 2 - 3 basis points and peaked at 37 basis points over a similar time frame4.

Massive drift

Pre- and post-stress portfolio weights for average and custom LDI portfolios

Pre- and post-stress portfolio weights for average and custom LDI portfolios

Source: BlackRock, April 2020. The asset class weights are based on the average asset allocation of the corporate defined benefit plans for which Pensions & Investments includes an asset allocation breakdown as of 9/30/2019. Asset class mapping is assigned by BlackRock. Time period of recent market volatility is 12/31/2019 – 3/31/2020. Custom Rate Overlay represents a combination of government bond indices to hedge the pension liability profile. Please see Appendix for more details, including the benchmarks that BlackRock assigned to each asset class.

Shaping the recovery

Market drawdowns and recoveries have taken various shapes historically. To help plan the path forward, we have illustrated potential L-shaped, U-shaped, and V-shaped asset recovery scenarios and analyzed the impact on pensions over time. Depending on the shape of the recovery, some pension plans may regain their pre-stress funded status levels in about a year, or more gradually over time. The Recovery shapes and sizes chart highlights the funded status impacts of pension portfolios under the different market recovery scenarios. 

Recovery shapes and sizes

Illustrative asset recovery scenarios and potential impact on funded status

Illustrative asset recovery scenarios and potential impact on funded status
Illustrative asset recovery scenarios and potential impact on funded status

Source: BlackRock, April 2020. Recovery scenarios are for illustration purposes only; this information does not reflect any specific account or portfolio. Recovery scenarios are approximated by shocking MSCI ACWI by +/-10% for each incremental 7% market move; change in funded status assumes assets and liabilities are shocked by amount of stress PnL.

Robust portfolio construction and risk management are of utmost importance, particularly during such volatile periods. With declines in funded status, and potential reductions in voluntary contributions, pension plans may need higher returns to achieve funded status objectives. As a result, many plans will need to reassess their SAA and LDI programs to ensure they are taking the appropriate level of risk to efficiently achieve the desired end-state targets. 

Additionally, portfolios that drift with the market and are not rebalanced may result in concentrated positions that deviate from the SAA. We estimate that pensions that have not rebalanced their portfolios in response to recent market moves may be inadvertently taking active risk of approximately 1.6% - 2.9% relative to their original asset portfolios (See the Why rebalancing matters chart). Once the appropriate level of strategic risk is determined, taking further active risk inadvertently may have unintended consequences. 

Robust portfolio and risk management programs are critical to act strategically and position for potential opportunities. We favor rebalancing toward target weights, but caution investors from making changes without considering transaction costs, market liquidity and cash requirements, among other factors. In the face of wide spreads, high issuance, and Fed support, plans that use custom LDI strategies may want to consider the tradeoffs between rates and credit exposure, if capital-efficient exposures can be used to potentially improve the overall yield. The Opportunistic credit allocation in LDI chart highlights the potential benefits of adding to credit, particularly if investment grade spreads continue to narrow toward pre-crisis levels. While we believe it may be too soon to overweight equities, it may be prudent to start leaning against market moves through rebalancing as well as positioning to take advantage of market dislocations, particularly in credit and private markets.

Why rebalancing matters

Active risk of drifted portfolio relative to original portfolio and effects under different scenarios

Average allocation: Active risk vs. original
Custom LDI allocation: Active risk vs. original

Risk: 84% confidence interval, 231 constant weighted monthly observations, 1yr horizon, as of 3/31/20; see “Risk Factor Glossary” in the Appendix  for additional risk details and “US Corporate Pension Plan Allocations and Benchmark Mapping” in the Appendix for details regarding the indexes used to represent each asset class.  Historical scenarios simulate each plan’s current portfolio through historical time periods.  Hypothetical scenarios simulate each plan’s current portfolio through hypothetical large market shocks and geopolitical stresses, with implied shocks. The performance shown is hypothetical, does not represent the performance of any existing portfolio, and does not reflect fees and expenses; if fees and expenses were included, the performance would be lower. It is not possible to invest directly in an unmanaged index. There is no guarantee that any portfolio will perform in this manner under similar scenarios going forward.  Please refer to “Stress Test Scenarios Methodology, Assumptions and Limitations”  in the Appendix for additional information. Liability is modeled with generic cash flows discounted at the Bank of America Merrill Lynch US AAA-A Discount Curve. The assumed funded ratio is sourced from the Milliman Corporate Pension Funding Study on the 100 largest corporate defined benefit pension plan sponsors as of 12/31/2019. Change in funded status assumes assets and liabilities are shocked by amount of stress PnL.

Opportunistic credit allocation in LDI

 Evaluating 5% opportunistic allocation to credit in custom LDI

Hypothetical portfolio comparison

Risk: 84% confidence interval, 231 constant weighted monthly observations, 1yr horizon, as of 3/31/20; see “Risk Factor Glossary” in the Appendix for additional risk details and “US Corporate Pension Plan Allocations and Benchmark Mapping” in the Appendix for details regarding the indexes used to represent each asset class.  Historical scenarios simulate each plan’s current portfolio through historical time periods.  Hypothetical scenarios simulate each plan’s current portfolio through hypothetical large market shocks and geopolitical stresses, with implied shocks. The performance shown is hypothetical, does not represent the performance of any existing portfolio, and does not reflect fees and expenses; if fees and expenses were included, the performance would be lower. It is not possible to invest directly in an unmanaged index. There is no guarantee that any portfolio will perform in this manner under similar scenarios going forward.  Please refer to “Stress Test Scenarios Methodology, Assumptions and Limitations” sin the Appendix for additional information. Liability is modeled with generic cash flows discounted at the Bank of America Merrill Lynch US AAA-A Discount Curve. The assumed funded ratio is sourced from the Milliman Corporate Pension Funding Study on the 100 largest corporate defined benefit pension plan sponsors as of 12/31/2019. Change in funded status assumes assets and liabilities are shocked by amount of stress PnL.

Calvin Yu, CFA
Head of BlackRock’s Client Insights Unit
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Alison MacArtney
Client Portfolio Manager, Liability Driven Investing
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