Corporate pensions

Calvin Yu: For the first time since 2007, the average corporate defined benefit pension plan is estimated to be over 95% funded. But, there's a lot of dispersion across companies, and how the pension impacts the corporate enterprise may influence the risk tolerance.

For example, am I taking the right risk? How does my plan impact my net income and free cash flows? Are my peers managing their plans differently?

To address these questions, I'll share 3 key insights from a recent client engagement, which potentially helped the client better preserve funded status and position for the future.

Hi and welcome back to another Quick Insights.

I'm Calvin Yu, head of the Client Insight Unit at BlackRock, and we help deliver portfolio insights to investors. In this series, we talk about common investment challenges and highlight ideas to help achieve the desired outcomes.

We released a corporate pension peer study, and a lot of clients have leveraged this to analyze their pension as well as their peers, and studied the implications on the broader enterprise.

The purpose of this study though is not trying to say who’s winning or losing, because markets give and take all the time. How many CIOs and CFOs find this helpful is by studying the strategic choices of others. This brings another perspective, and many have even used these findings in their Board discussions.

So what factors can affect a pension?

Well that brings me to the first insight, which is Evaluating the Enterprise.

We analyzed the funded status and plan materiality of the client as well as their industry peers. We’ll refer to this client as Company X.

While better funded plans may de-risk to preserve funded status, how material the liability is relative to the market cap could impact the capacity to take risk.

From an income statement perspective, the plan’s strategy could impact pension expense, which could drive sensitivities relating to net income.  

And from a cash flow perspective, the plan deficit may have different impacts on cash flows from operations.

So how can a plan efficiently earn returns needed to meet its objectives?

Well that brings me to the second insight, which is Honing in on the Hurdle.

We analyzed the hurdle rate of return required to meet end state objectives, and break down the components coming from interest cost, service cost, and so forth.

In Company X’s case, they need a 7.2% return to reach the end state.

We do the same calculation for the peers, and as we look at the portfolios, you can see various factors affect plans differently.

For example, Company X is just over 70% funded, so they focus on growth assets, particularly in Alternatives and Other asset classes. This drives higher risks and returns, where their reported Expected Return exceeds the hurdle rate of return.

Meanwhile, if we look across the peers, Peer I also maintains a large allocation to Alternatives and Other asset classes. But they structured the portfolio so their Expected Return is more in line with the hurdle rate.

As a result, even though Company X has a high expected return per unit of risk from a standalone basis, when you incorporate the liabilities and look at expected returns per unit of surplus risk, Peer I looks more efficient.

So how could that impact the funded status over time?

Well that brings me to the third insight, which is Narrowing the Cones.

We analyzed the historical funded status journey, and outlined the potential future paths.

While Company X is expected to be fully funded over time, the question is how can we narrow the cone of outcomes, so we can efficiently target growth, without taking a lot of surplus risk, which in draw down scenarios, may require significant contributions.

From this study, we partnered closely with the client to analyze different parts of their portfolio, such as exploring capital efficiency, evolving LDI beyond long corporate, and aligning growth to reduce surplus risk. This helped the client build an efficient portfolio that was more in line with their objectives.

So if you want to learn more about analyzing the positioning of your plan, please reach out to your BlackRock relationship manager.

Thanks for watching and I'll see you with the next Insight.