By Nilly Essaides
The Pension Protection Act (PPA) was supposed to herald a substantial shift from equities into fixed-income instruments by pension fund managers. The reason: The PPA imposed progressively higher funding targets and then stiffer penalties on those that came up short.
By rebalancing their portfolios and reducing equity allocation in favor of longer-term debt, pensions could minimize or even eliminate their funding-variance risk, i.e., the chance that a move in interest rates or market decline would decrease the value of their assets vs. their liabilities, thus pushing them below the 100 percent funding target.
CONFLICTING EVIDENCE
Broad industry surveys, however, have so far failed to detect such a broad move away from equities. For example, a January 2007 global pension study published by Watson Wyatt revealed that pensions have yet to make a discernible shift into bonds (see charts below). According to the Watson report, the average equities’ allocation of funds, globally, has barely budged.
“Funds carry around 20 percent overweighting to equities and a significant underweighting to bonds,” the Watson report noted.
“When the PPA passed, everybody thought that LDI was going to drive investment strategy, with a clear shift away from equity. In practice, we have seen little of that,” said Adam Frieman, a principal with Probitas Partners, a boutique firm
specializing in alternative asset classes.
However, countered the CIO of one of the country’s top-20 pensions, “That is not what I am hearing from my colleagues. Some of the largest plans, including ours, have materially reduced their equity beta exposure,” he noted. “That trend [not reallocating] does not make sense given the three big movements: 1) higher funded status after the 2001-2003 perfect storm; 2) new FASB regulations; and 3) much higher contribution volatility due to the PPA rules.” Some of the top-20 funds have made their reallocation activities as part of the transition to the PPA very public, e.g., General Motors and Boeing.
“I suspect others are not far off, and I’ve looked at a few smaller plans as well,” the CIO said. “They all seem to be either taking down equity into more alternatives, or straight into fixed income, using a hedge out of equity to manage the alpha,” he said.
“They get the fixed-income market exposure rather than selling equity.”
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CHANGE DRIVERS According to the Watson Wyatt study, plan sponsors will soon snap out of their asset-allocation inertia, because of the following change drivers: • Increased use of LDI to help minimize the funding variance risk; • Increased use of absolute-return mandates; • Alpha-beta separation and integration, using derivatives; • Beta prime innovation, capturing systemic ‘alpha’ effects in index form; • The reduction in DB funds’ risk budgets to match sponsor covenant and risk appetite; and • Finally, the increased influence of funds on product pricing and design. |
RECONCILING THE NUMBERS
On the surface, the two views conflict. A deeper look reveals a more nuanced answer. The data on funding status and portfolio allocations is an average only, which may well hide the more extreme divergences that exist within the pension universe.
Over- vs. underfunded. Fully or overfunded plans are more inclined to follow LDI’s lead, because they have an asset base that’s matched or even exceeds their liabilities. Principal protection and funding-variance risk mitigation are thus primary concerns. In contrast, underfunded plans have to “chase the yield” in order to catch up, and thus are more inclined to maintain or even increase equity and alternative asset allocations.
Recent reports show that the S&P 500 companies are fully funded and may even become overfunded this year. But the nation’s top-20 funds are in many cases so substantially overfunded that they skew the averages. A couple of plans are overfunded by more than $10bn or even $20bn. Thus, for every overfunded pension there are several plans that may be substantially underfunded, particularly smaller ones that therefore need to generate higher returns.
Active vs. not. Another key differentiator is whether the plan is static or still taking on new liabilities. Given the yield curve, Mr. Frieman of Probitas noted, if a company’s liability “return” is 8-9 percent annually, 10-year bond yields of under 5 percent would create a negative spread. In that case, matching duration won’t produce the funding-variance hedge.
However, static plans (as long as they are fully funded) are largely “insulated” from the effects of the yield curve. “Liabilities are subject to the same yield curve,” explained the investment head of one large plan. “We did a surplus volatility analysis as we prepared for our transition,” he noted. “The rate of return on the liabilities is just the interest rate plus cost,” he explained. Thus there’s no real spread between the fixed-income asset returns and the liability cost. Of course, plans do make choices about the “notional” amount of that variability hedge. No one matches dollar for dollar. “We still have a substantial amount in equities.”
The equities rally. The long rally in stocks has held back some of the transition work. Looking at allocation data over the past decade, the Watson study revealed that “asset allocation tends to ‘drift’ with market movements, as limited amounts of pension assets are rebalanced to a strategic asset allocation benchmark.” For example, in 2001, just after the equity bubble popped, funds increased bond allocations and cut back equities. “Equity content has increased more recently,” the study pointed out, “with the reverse in the relative performance of bonds and equities over the 3 years from the end of 2003.” (see charts below).
Because the PPA has shrunk the “smoothing” period over which pensions can measure their portfolio returns, they may be more susceptible to such drifting, in particular under-funded plans. But no one is expecting the rally in stocks to last. “One bad earnings report could quite readily re-set the equity valuation bar downward,” Mr. Frieman of Probitas Partners noted.
Attractive alternatives. The pension fund CIO, Mr. Frieman, and the Watson survey concur on one main point: Pensions are putting more and more money into alternative assets, from real estate, to absolute-return mandates, to private equities and even timber. “Other assets, especially real estate and to a lesser extent hedge funds, private equities and commodities have also shown growth in recent years,” the Watson study noted. With the real estate market under a dark cloud, private equities are gaining “portfolio share.” According to Mr Frieman, “the private equity market continues to become increasingly mainstream with more proactive risk management, increased liquidity, and above debt-like returns.” Mr. Frieman is currently working with a number of large US pension funds that are actually increasing their allocation to private equity in place of fixed income, in order to offset relatively low yields available in the bond market.
At the same time, pension funds are deploying interest-rate derivatives and total-return swaps to alter the duration or return profile of their assets. “Pensions are 10 years behind treasuries in using derivatives,” one ex-treasurer said. But the PPA is forcing them to catch up fast (see story below).
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REDEFINING RETURN As more pension managers become comfortable with derivatives—and some become more concerned with principal protection under LDI—banks are structuring new products designed to provide principal protection with an equity “kicker.” For example, principal-protection notes combine: 1) an investment in a zero-coupon, 10-year security at 85-86 (yielding 1 – 2 percent); and 2) using the difference to par to purchase a call on the S&P 500 with a cap, e.g., at 80 percent of the appreciation. The structured notes provide an above-debt return, as long as the market appreciates over 5 percent. If the market stays flat or declines, the notes underperform a debt instrument; if the market surges, investors give up the |
The time lag. Finally, pension funds have time to adjust their portfolios. There’s a three-to-four-year transition period, during which the PPA has given plan sponsors time to adjust before the full funding targets and penalties kick in.
While the 2006 data showed no uptick in bonds at the expense of stocks, the Watson study concluded that things are about to change. “We see in the recent trends a levelling off in the growth of equity content and anticipate a point of inflection in which both bond allocations and alternative assets are set to grow.”
“There’s clearly some inertia around traditional long-term equities that has yet to change,” one pension fund manager said. “But it’s only in 2009-10 that the funding volatility will kick in; so companies are shifting gradually.”