At various points in the last 3-6 months, we’ve heard fixed income market chatter about sizable buying in the long end of the curve coming from pensions. While the long-term trend of increased allocations to long duration is fairly well-understood, significant deviations from this trend can have the potential to impact the market, given the substantial amount of assets managed by pensions.
As noted in my previous blog post from August 25, 2016 (Pensions: Still Patiently Waiting for Interest Rates to Rise (Don’t Fear Duration in the Meantime)), most U.S. corporate pension plan sponsors are planning to allocate more of their investments to liability hedging strategies at some point in the future. This generally means that they will be buying more long duration fixed income instruments as their funded status improves over time. Since this shift towards liability hedging strategies is a trend that has been slowly happening over the past decade or so, it may take another decade or more to get to the point where the majority of pensions have completed this reallocation. In the meantime, there are several other drivers to be aware of that can affect the speed of this reallocation.
Figure 1 below illustrates the allocation between the two main asset classes held by pensions from fiscal year-end 2005 through 2016. The fixed income allocation was around 28% of total assets at the beginning of this period and around 44% by the end. Since corporate pension plans in total had assets of $2.3 trillion at the end of 2005 and $2.9 trillion in 2016, this represents an increase in fixed income holdings of over $600 billion over that timeframe.
Figure 2 illustrates the monthly funded status history since the end of 2015 for a sample plan with characteristics similar to the average S&P 500 pension plan. Funded status reached a recent low point of 75% in June 2016 and a high point of 87% in January 2018. Since many pensions intend to increase their fixed income allocation as funded status improves, the increase in funded status over the past few years looks to have supported the longer-term trend of greater allocations to fixed income.
There are various items that can affect the speed of the long-term trend of increasing fixed income allocations. One such item is pension contributions. Voluntary contributions in excess of the minimum required amount have been popular in recent years, either as an attractive use of debt issuance proceeds or, more recently, as a result of the recent change in tax law. Companies have been accelerating their voluntary contributions since right before the passage of the Tax Cuts and Jobs Act of 2017. Since companies with calendar year tax years can deduct pension contributions at their 2017 tax rate until September 15, 2018, we may not yet have seen the end of these greater contributions. And since contributions increase a pension’s funded status, voluntary contributions have led to greater allocations to fixed income in late 2017 and YTD 2018.
Another item that can drive fixed income flows is rebalancing between asset classes. Relative performance of various asset classes can lead to rebalancing when the asset class allocations drift beyond the range allowed in the investment policy. The outperformance of equities compared to fixed income in 2017 and January 2018, as illustrated in Figure 3, led some pensions to rebalance from equities into long duration fixed income. The equity outperformance vs. fixed income ended in early February, so it appears that this driver of inflows into long duration has run its course for now.
Figure 4 summarizes the items discussed above that have contributed to recent fixed income buying from pensions.
Charles Dow, a historic figure in finance and investments, compared market moves to ocean movements, with tides, waves and ripples. While the analogy doesn’t fit perfectly with changes in pensions’ fixed income allocations, it can help illustrate the variety of forces involved. The long-term asset allocation trend shifted directions towards increasing fixed income allocations 10-15 years ago and, more recently, the shorter-term waves/ripples of tax law changes and market sector performance acted to bolster this long-term trend.
 Investment Company Institute Quarterly Retirement Market Data