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
To assist plan sponsors with managing interest rate and credit spread risk, in Exhibit 2, we track our estimate of the discrepancy between the actual Libor interest rate swap curve and our fair value assessment of the Libor interest rate swap curve. When the grey line is at zero, interest rates are estimated to be at fair value. With the line below zero, interest rates, in our view, are low. Interest rates moved away from our estimate of fair value during the quarter, as rates decreased. We expect interest rates to rise in the long-run, as they move toward equilibrium levels.
Exhibit 2: Corporate bond spreads and Libor swap curve relative to our assessment of fair values
Changes in the spread between the corporate bond-based discount curve and the Libor interest rate swap curve cause changes in the pension liability discount rate, which in turn causes changes in the liabilities’ present value. We refer to this as liability credit spread risk. Whereas managing interest rate risk via swaps and/or Treasuries is relatively straightforward, managing credit spread risk is more challenging for three reasons:
- Liability credit is not investable: Corporate bonds are subject to default and downgrade risk while liability returns are not.
- There is no capital-efficient risk management tool: We view synthetic exposure to the Credit Default Index (CDX) as an imperfect hedge of liability credit risk.
- Connection to risky assets: During periods of economic stress, equities and other risky return generation assets fall and credit spreads widen. Therefore, the credit profile of the return generation component of a liability-driven investment (LDI) solution needs to be taken into account when constructing the credit profile of the liability hedge.
When the outlook for credit is positive, we seek to hold some credit instruments in the liability hedging portfolio. The green line in Exhibit 2 represents our estimate of the discrepancy between the actual corporate bond discount spread and our fair value assessment of the corporate bond discount spread. When the line is at zero, discount rate spreads are estimated to be at fair value. When it is above zero, credit spreads, in our view, are wide. Discount rate spreads slightly moved farther away from fair value during the second quarter as credit spreads widened by a small margin. We still find credit to be somewhat attractive, although discount rate spreads are not substantially away from fair value.
Funding ratios measure a pension fund’s ability to meet future payout obligations to plan participants. The main factors impacting the funding ratio of a typical US defined benefit plan are equity market returns, which grow (or shrink) the asset pool from which plan participants’ benefits are paid, and liability returns, which move inversely to interest rates.
Liability indices: Methodology
The iBoxx US Pension Liability Index – Aggregate mimics the overall performance of a model defined benefit plan in the US, taking into consideration the passage of time and changes in the term structure of interest rates. The index is based on actual liability profiles, and mimics the investment grade yield curve. It is therefore more appropriate than most existing indices for measuring the performance of defined benefit plans. This index (along with its related active member and retired member indices) is published daily, using the LIBOR interest rate swap curve as the discount curve, a highly liquid universe. This provides the flexibility to use combinations of the indices in order to accurately represent customized liability profiles based on a plan’s specific participant population.
Pension Protection Act (PPA) liability returns are approximated by the Barclays Capital US Long Credit A-AAA Index. This index broadly reflects the duration and credit characteristics of the PPA discount curve that is used to discount expected pension benefit payments for US defined benefit pension plans.
Asset index: Methodology
UBS Global Asset Management approximates the return for the ”typical” US defined benefit plan using the reported asset allocation of the corporate plan subset of the Pension & Investments 1000. The series is constructed using the reported asset allocation weightings and publicly available benchmark information, with geometrically linked monthly total returns.
Pension Fund Fitness Tracker: Methodology
The US Pension Funds Fitness Tracker is the ratio of the asset index over the liability index. Assuming all other factors remain constant, it combines asset and liability returns and measures the impact of a “typical” investment strategy on the funding ratio of a model defined benefit plan in the US due to interest rollup, change in interest rates and typical asset performance, but excludes unique plan factors, such as contributions and benefit payments.