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- Aggregate single-employer plan funded status rose to nearly 100% in the fourth quarter, the highest level since September 2008.
- In addition to overall asset class de-risking, plan sponsors may consider further protecting funded status gains by reducing equity beta within return-seeking assets (e.g., via multi-sector credit) and implementing a more precise credit spread hedge (e.g., by introducing an intermediate- or core-duration credit component).
- At the same time, generating alpha to offset adverse assumption changes and plan experience remains important. Given a strong macro backdrop, tight credit spreads, and the potential for heightened issuer return dispersion, current opportunities include a modest short duration positioning and a continued focus on issuer selection within credit.
- Pension risk transfer (PRT) has likely set a record for 2021 and continues to be a strategic consideration. However, contribution relief, balance sheet considerations, and new tools to evaluate and potentially off-load mortality risk may complicate PRT decisions.
Quarterly Funded Status Drivers
Figure 1 : Funded Status Drivers
Source: Bloomberg Index Services, Milliman, MSCI. The funded status and discount rate are for the Milliman 100 Pension Funding Index.
Many plan sponsors experienced an improvement in funded status during the fourth quarter, as equity markets rallied and credit spreads widened modestly, offsetting a decline in long Treasury yields. According to Milliman, the aggregate funded status of the 100 largest corporate pension plans ended the quarter at 99.6%, representing an increase of 2.5% since the prior quarter end and a meteoric 9.3% increase since the beginning of the year. Despite a historically high Consumer Price Index print in November, healthy GDP growth (even in the face the Delta and Omicron variants), and the Fed’s tapering announcement, the yield curve actually flattened with the 30-year Treasury yield falling 14 bp2, the 10-year yield remaining relatively stable at 1.51%, and the 2-year yield rising 46 bp. The Omicron variant broke credit spreads out of an 8-month period of relative stability, as the Bloomberg U.S. Long Credit Index spread rose to 138 bp in early December and ended the quarter at 130 bp. This was 7 bp higher than at the end of the third quarter, but still well-below its 10-year average of 176 bp. Similarly, equity markets (as measured by the MSCI All Country World Index) erased nearly two-thirds of their quarter-to-date gain in late November, but made up most of that decline in December.
Positioning Pension Assets for 2022
Following a sharp increase in funded status in 2021 and broad de-risking steps along pension glide paths, plan sponsors may now want to consider incrementally reducing funded status risk by “fine-tuning” the investment strategy and (re-)exploring targeted non-investment de-risking options (such as plan amendments, lump sum windows, or pension risk transfers). However, alpha generation still remains relevant and not only for accruing plans or plans that are still underfunded on an accounting or termination basis. A good reminder of that came in October in the annual mortality assumptions update from the Society of Actuaries, which, if adopted, would increase typical accounting liabilities by 0.2% to 0.4%, the first such increase since 2014. While this increase may be offset by reductions due to COVID-related deaths, other factors (e.g., elevated early retirements) may also increase liabilities. Thus, guarding against adverse assumption changes and plan experience continues to be important.
Below we outline a few investment ideas that may help balance the twin goals of protecting funded status and generating alpha in today’s environment. We also share observations on pension risk transfer and mortality risk.
Return-Seeking Assets Diversification
After three consecutive years of double-digit returns in the equity markets led largely by high-priced growth stocks (especially technology), it may be worth considering a modest reduction in equity beta (aside from rebalancing into liability hedging assets). One such approach would be to incorporate an allocation to low-duration, multisector credit such as bank loans and high yield bonds, and, if the investment horizon allows, private credit. Within equities, given persistent growth-value valuation differentials and potential headwinds for the technology sector, an overweight to value over growth may also be sensible. In our view, these strategies could reduce risk while continuing to emphasize return generation.
Figure 2: Sample Fully Funded Plan Asset Allocations
Source: Dodge & Cox.3 CSHR is the credit spread hedge ratio.
Asset Allocation A
While well hedged from an interest rate risk perspective, the plan is overhedging liability credit spread risk, both in total (111% credit spread hedge ratio) and at the long end of the curve (126% credit spread hedge ratio in the 10-30 year maturity range). As a result, the asset allocation exhibits a bias towards tightening spreads, and spread widening is likely to reduce funded status.
Asset Allocation B
By shifting 15% from Long Credit to Intermediate Credit (and adjusting the completion portfolio to maintain 100% interest rate hedge ratio across the curve), Asset Allocation B alleviates these risks. The total credit spread hedge ratio falls to 93%, and the credit spread hedge is distributed across maturities more evenly. This is also reflected in funded status risk, which drops by almost 20%, from 2.9% to 2.4%.
It may be reasonable to maintain a total credit spread hedge ratio of under 100% due to the presence of return-seeking assets, which are typically correlated with credit spreads.
More Precise Credit Spread Hedging
Analogous to completion (which seeks to hedge interest rate risk granularly across maturities), a more refined approach to credit spread hedging can also reduce funded status risk, especially for well-funded and mature plans. In particular, incepting an Intermediate Credit allocation (funded either from return-seeking assets or Long Credit) can help mitigate the possibility that liability credit spread risk, especially at the long end, is overhedged, while also potentially providing a more even hedge across maturities (Figure 2). Furthermore, adjusting the balance between Treasuries and credit to match the nature of the liability discount rate (i.e., more Treasuries for a broad AA discount rate and more credit for an above-median or otherwise “high” AA discount rate) can also help reduce funded status risk. Reflecting these considerations, we have noted growing interest in our Intermediate Credit strategy over the last year.
Figure 3: U.S. Treasury Yield Curves
Source: Bloomberg Index Services
A Modest Tactical Interest Rate Bet
While this quarter’s yield curve flattening was a good reminder that interest rate bets do involve risk, a modest duration underweight may continue to make sense for plan sponsors willing to take such risks. While Treasury yields are still well below their pre-COVID levels, and even lower than March 2021 levels at the long end of the curve, we are wary that the strong economic backdrop, elevated inflation, and the upcoming Fed tightening may increase the potential for yields to rise and for the curve to steepen (Figure 3). We remain approximately 0.75 years, or 5%, short duration in our full-discretion Long Credit strategy.
Continued Allocation to Active Credit
While long credit spreads finally broke out of their 2021 range in the fourth quarter, investment-grade (IG) credit remains a natural liability hedge and a source of potential alpha relative to liabilities. Although overall credit fundamentals remain strong and forecast supply is not overextended, spread volatility and issuer dispersion may increase due to continuing inflationary pressures, increasing M&A activity, and potentially rising interest rates. This dynamic may provide opportunities to generate credit alpha through both issuer selection within IG credit and tactical out-of-benchmark positions in select below-investment-grade issuers, taxable municipals, and Agency mortgages. For example, the short-lived spread widening at the end of November allowed us to incrementally add exposure in high-conviction names at attractive valuations.
Pension Risk Transfer, Contributions, and Mortality Risk
Although 2021 was likely a banner year for pension risk transfer (PRT) activity, it was also a momentous year for pension contribution relief, due to legislative actions—notably the American Rescue Plan Act in March and the Infrastructure Investment and Jobs Act in November. The new contribution regime, better tools for estimating plan-specific longevity, and potential innovations in the longevity risk space may make PRT decisions more complex going forward.
In the third quarter, staggering $16.5 billion in U.S. pension risk transfers (PRT)—a quarterly amount not seen since the GM and Verizon mega-deals of 2012—likely pushed full calendar year 2021 PRT activity into record territory. With continued strong funded status, a growing and well-capitalized group of insurers bidding on PRT, and plenty of pension liabilities still available (e.g., PRT still comprises only 1.0% to 1.5% of U.S. single-employer liabilities), we anticipate industry-wide PRT activity to remain strong in 2022.
Still, the economics of PRTs need to be carefully evaluated, especially for large plan sponsors who have already transferred the most attractive liabilities. In particular, transferring liabilities reflecting complex benefit formulas (such as cash balance plans with bond-based crediting rates), healthy retiree groups, and terminated vested participants remains more costly and may not be as advantageous in light of the reduced contribution requirements. Furthermore, thanks to their actuaries and third-party providers, plan sponsors can now more granularly estimate their population-specific mortality risk, reflecting not only age and gender, but also socioeconomic status and geographical location, which puts them in a better position to evaluate—and potentially reject—PRT bids. Finally, despite the attendant risks, some plan sponsors may view an overfunded plan as an asset that generates pension income and a tool in potential M&A transactions that involve underfunded plans.
In conclusion, we note that the PRT toolkit for U.S. plan sponsors may expand in 2022 to include a longevity risk transfer (LRT) product, akin to longevity swaps, which are common in the UK pension space. At a high level, LRT allows a plan sponsor to off-load mortality risk to an insurer: a plan sponsor pays the insurer a specified, fixed stream of pension cash flows plus a specified annual premium in exchange for the insurer paying actual benefit payments to plan participants. Unlike PRT, which removes all pension risk at once, LRT leaves the plan on the balance sheet, allows for more plan sponsor flexibility over time, and is likely less costly (as the plan sponsor retains investment risk). These factors may make LRT attractive to some plan sponsors.
We would welcome the opportunity to speak with you about your pension risk management objectives for 2022 and beyond.
The above information is not a complete analysis of every material fact concerning any market, industry, or investment. Data has been obtained from sources considered reliable, but Dodge & Cox makes no representations as to the completeness or accuracy of such information. Opinions expressed are subject to change without notice. Information regarding yield, quality, maturity, and/ or duration does not pertain to accounts managed by Dodge & Cox. The above returns represent past performance and do not guarantee future results. Dodge & Cox does not seek to replicate the returns of any index. The actual returns of a Dodge & Cox managed portfolio may differ materially from the returns shown above. This is not a recommendation to buy, sell, or hold any security and is not indicative of Dodge & Cox’s current or future trading activity. The securities identified are subject to change without notice and may not represent an account’s entire holdings.
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance, L.P. and its affiliates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, shall have no liability or responsibility for injury or damages arising in connection therewith. The Bloomberg U.S. Long Credit Index measures the performance of investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related debt with at least ten years to maturity. It is composed of a corporate and a non-corporate component that includes non-U.S. agencies, sovereigns, supranationals and local authorities.
The MSCI ACWI (All Country World Index) Index is a broad-based, unmanaged equity market index aggregated from 50 developed and emerging market country indices. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This publication is not approved, reviewed, or produced by MSCI.
1 The information in this paper should not be considered fiduciary investment advice under the Employee Retirement Income Security Act. This paper provides general information not individualized to the particular needs of any plan and should not be relied on as a primary basis for investment decisions. The fiduciaries of a plan should consult with their advisers as needed before making investment decisions.
2 One basis point is equal to 1/100th of 1%.
3 For illustrative purposes only. The plan is assumed to be fully-funded. Funded status risk reflects volatility and correlations for relevant market indices for the 10-year period ending December 31, 2021 and accounts only for investment component of funded status risk.