Pension fund funding rations dipped in Q2

The UBS Global Asset Management US Pension Fund Fitness Tracker, a quarterly indicator highlighting the underlying health and volatility of a typical US corporate defined benefit pension plan, found that the typical pension plan’s funding ratio decreased by slightly less than 2% during the second quarter.

This result was primarily driven by two factors:

  • Increased liability values resulted from a strong rally in US Treasury yields. This decrease in interest rates, which was only marginally offset by a widening of credit spreads, led to a lower corporate bond yield curve and pension discount rate.
  • Performance was mixed across asset classes, with a slight increase in global equities and sizable increases in fixed income assets, leading to somewhat positive returns on pension assets.

Commenting on the results, Francois Pellerin, Head of Asset Liability Investment Solutions, said “For many sponsors, Q2's adverse performance has erased more than half of Q1's funded status improvements. Although funded positions are still well ahead of where they were at this time last year, sponsors who have adopted a pension risk management framework have experienced higher funded status protection during Q2.”

Exhibit 1: Decreased funding ratio driven by increases in liabilities and flat return in assets

US Pension Fund Fitness Tracker of the typical US corporate plan’s funding ratio

For the second quarter, a typical plan’s asset pool returned approximately 1.5%, based on the average corporate plan's reported asset allocation weightings and publicly available benchmark information. Following a healthy April, risky asset markets weakened during the remainder of the second quarter in the face of generally poor economic data and sovereign debt concerns. However, in late June, news of the Greek parliament approving legislation to implement austerity measures, and presumably avoiding default, resulted in a rally in global equities leading into the close of the quarter. The S&P 500 Total Return Index finished the quarter up approximately 0.1%, underperforming other developed markets, with the MSCI EAFE index finishing up approximately 1.6%.

Bond markets rallied throughout the second quarter, as growing concerns in global macroeconomic conditions and sovereign debt drove increasing demand for fixed income placing downward pressure on bond yields. The 10-year US Treasury yield decreased by 31 basis points, finishing the quarter at 3.16% as compared to the March 31st yield of 3.47%. High-quality corporate bond credit spreads, as measured by the Barclays Capital Long Credit A+ option-adjusted spread, ended the quarter approximately 2 basis points wider. As a result, pension discount rates (which are based on the yield of high-quality investment grade corporate bonds) decreased by roughly 15 basis points during the quarter. For the quarter, liabilities for a typical pension plan increased by approximately 3 %. (Please see disclosures for assumptions and methodology.)

A note on hedging pension liability discount rate risk
According to current accounting standards, expected pension benefit payments are to be discounted using a discount curve that is based on the yields on high-quality corporate bonds. Any change in the investment grade corporate bond yield curve will change the discount curve, which in turn, will change the present value of the liability. Changes in the corporate bond yield curve can be decomposed into changes in the: (1) Libor interest rate swap curve and (2) the corporate bond credit spread curve (relative to Libor). Therefore, liability discount rate risk can be split into interest rate risk and credit spread risk.

Plan sponsors should set an investment strategy that explicitly manages the four key drivers of funding ratio risk - market, interest rate, credit spread, and active management risks. Further, in unstable and volatile markets such as today, sponsors should manage these key risks dynamically as the plan's funding ratio and market environment change.

Next page: A roadmap for plan sponsors

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