Corporate plan sponsors had an interesting 2012. The benchmark 30 year U.S. Treasury yield was essentially unchanged for the year, despite trading in a wide 100bps range. After peaking around 3.50% in 1Q, rates receded below 3%, thanks to Euro-area fiscal concerns, Fed buying, and U.S. fiscal and regulatory uncertainty. Pension plan assets benefited from a 15%+ rally in broad equity indices supported by the Fed’s generous Quantitative Easing policies. Unfortunately that didn’t mean improvement in funded status as high quality corporate spreads, a component of the pension liability discount rate, continued to grind significantly tighter. The yield of the Barclays Long Corporate AA Index fell from 4.52% to 3.74% during the year. The Moving Ahead for Progress in the 21st Century Act (MAP-21) regulatory funding changes significantly reduced required contributions for plan sponsors, as the new legislation called for liability valuations to be based on the significantly higher 25 year average of corporate yields. Nevertheless, while most plans welcomed the relief, they continued to use real time yield measures for setting contribution policy.
Plan sponsors increasingly realize that the pension plan is part of the corporate capital structure, a relationship that the executive suite is reminded of at every quarterly earnings call. There is also a distinct pro-cyclicality to the pension plan’s footprint on the sponsoring company’s own financial flexibility. The crucial question for plan sponsors is not why should fixed income assets be bought at multi-generational low interest rates, but rather when is the right time to start reducing asset-liability mismatches. The questions are being asked despite the yield environment and irrespective of current asset allocation or plans for regulatory funding relief. The decision by some larger pension plans to defease a portion of their liabilities by purchasing annuities has only accelerated these discussions. While the risk transfer option may be attractive to many plan sponsors, the existing capacity in the annuity market would likely cover only approximately 5% of outstanding pension liabilities. Thus, long duration fixed income will continue to be the favored choice for plans that want to de-risk.
In 2013, we expect more plans to adopt liability driven strategies and to formalize glidepaths that specify a de-risking plan as funded status improves; this includes instituting an investment discipline and an implementation plan centered on a liability hedge ratio. The move to centralized clearing for many liquid derivative instruments by the end of 2013 should reduce counterparty risk concerns (as the counterparty switches from an investment bank to an exchange), and may see more plans utilizing overlays as a way to reduce funded status volatility. As funding ratio improves, managing basis risk vis-à-vis liability discount rates leads to greater emphasis on credit; moreover, the Fed’s buyback program is forcing many investors out of long Treasury securities, increasing demand for credit. We are also seeing non-U.S. liability managers (pensions and insurance companies) looking to make allocations to U.S. corporates, because of the greater depth of the U.S. market compared to domestic markets. While demand for corporate bonds will likely be strong, the illiquidity of that market will remain. This will put a premium on managers with an informed credit research process and an extensive track record managing Long Credit portfolios across market cycles. These changes capture the ongoing evolution of corporate pension plan management well into 2013.