When the 2000 bubble burst, many of us characterized it as a "perfect storm" for pensions: the falling yields boosted the mark-to-market value of the pension liabilities hugely, while falling stocks crushed asset values. This left us with sharp erosion in funded ratios. Shortly thereafter, liability-driven investing (LDI) became a hot topic in finance committees and pension conferences. Like commuting Londoners, fiduciaries were warned to "Mind the Gap" between their assets and liabilities. Few moved fast enough on a large enough scale, so it's happening again ... big time. In this issue we will explore the current status of U.S. pensions and what plan sponsors can do to achieve sustainable, healthy pensions.
Simply put, we can calculate the relative health of a pension by comparing its current assets to its promised benefits (many of which will be paid decades into the future.) In the case of the latter, we need to discount the projected obligations to a present value using current interest rates (typically a long-term, high-quality bond rate such as Moody's AA). If the assets match the current value of the liabilities, the plan is considered 100% funded.
The funded status of the 100 largest U.S. corporate plans, illustrated in Figure 1, peaked in 1999 when these plans were, on average, 130% funded. At that time, sponsors were happy to assume 9%, 10%, even 12% returns on their pensions—although bond and stock market yields were only 6% and 1%, respectively. For those who did not embrace a "past is prologue" view of the world, it was painful watching this storm build and strike. By the end of 2002, the ratio had slipped to approximately 83%. The ensuing five-year bull market allowed plan sponsors to claw halfway back, reaching a funding ratio of 107% by October 2007, just in time for the second perfect storm to bear down on U.S. pensions. Milliman's October 2008 update showed funding levels had dropped to 92.7%, no doubt driven by the 23.7% decline in a 60%/40% model portfolio of S&P 500 stocks and Lehman Brothers (now BarCap) aggregate bonds. Pensions were only saved (in a relative sense) by the rise in corporate bond yields leading to a reduction in the value of their liabilities.
Sadly, the silver lining of higher discount rates vanished—in a hurry—in November. A back-of-the-envelope calculation indicates things got much worse. The 60/40 portfolio "only" lost 3%, but interest rates declined significantly. For example, the BarCap Aa Corporate Long Bond Yield dipped from 7.75% to 6.93%; the drop in Treasury yields was farther and faster. A lower discount rate means a higher net present value for liabilities. Assets down and liabilities up translated to a "guesstimated" funded ratio of 81%.
How could pensions be hit twice by a perfect storm in the same decade? After 2002, plan sponsors that wanted to immunize some portion of their portfolio were confronted with paltry long-term rates making a move to LDI prohibitively expensive in the eyes of decision makers. About the same time, the mega endowments, with their uber-diversified and alternatives-heavy portfolios, were held out as the best way to earn materially higher returns with significantly less volatility than the old "60/40" model pension portfolio. That's the reason-despite all of the talk about LDI and an acute awareness of asset/liability mismatches-pension tracking error to a liability index remained very wide.
At the time, pension leaders didn't consider LDI an important strategy. In fact, a study conducted by CREATE, a UK-based think tank, showed that LDI finished 12th when pension sponsors were asked which asset classes will best meet their funding needs over the next five years. Emerging markets equities, portable alpha, private equity, high-yield bonds, and real estate all were believed to be a better solution than LDI. Indeed, the "Yale Effect" had taken hold and pensions were well on their way to building sizable alternatives allocations. If the alternatives delivered their promises of higher returns and moderate volatility, then the pensions would not need to worry about their liabilities—or so they believed.
But alternatives haven't been immune to the take-no-prisoners market of 2008. As an example, hedge funds—measured by the HFRI Global Hedge Fund Index—were down 22.3% year-to-date through November 2008. REITs, as a proxy for real estate, were down 45.9%. And the true extent of the carnage in private equity won't be known for a few years.
So what to do now? We believe there's hope for increasingly distressed pensions. The forward-looking opportunities, however, require investment committees to reassess their priorities along four key criteria: