Are defined benefit (DB) pension funds in the US going to come back in fashion? You may think so, judging from three hints: good results in 2006, the shift to safer strategies such as liability driven investments and the shrinking employment market, which is encouraging companies to use DB plans as a valuable tool to attract and retain key employees.
Positive investment performances have boosted assets and higher discount rates have made for lighter pension liabilities: the two together have allowed employers to decrease their contributions while the funded status of corporate plans improved significantly during 2006, almost reaching 100%.
According to Milliman's seventh annual study of the financial reports of 100 large US corporations that sponsor DB pension plans, the average actual investment return on pension assets for 2006 was 12.8%, exceeding the median expected rate of return of 8.4%.
The discount rates used to measure plan liabilities increased to a median of 5.75% at the end of 2006 from the low of 5.5% in 2005, after declining incrementally each year from 7.5% at the end of 1999. As a result, pension liabilities increased only 1.9% in 2006, the lowest increase since 1999.
"Although new accounting rules forced most companies to reduce shareholder equity to recognise DB pensions and other post-retirement benefits, that reduction was about half of the impact that had been projected last year, due to the win-win year for the funded status of the plans," the Milliman report says.
Notwithstanding last year's good performance, corporate pension plans' sponsors are not resting on their laurels.
"The transition to mark-to-market accounting rules in the US is reducing the ability and willingness of corporate plan sponsors to tolerate market volatility within their pension funds, and thereby their ability to generate much-needed investment returns," explain consultants at Greenwich Associates, who have just published their 2006 US Investment Management Research Study, based upon 1052 interviews with US institutions, conducted last year.
"Plan sponsors in both the public and corporate sectors have begun investigating a series of investment and management strategies that are designed to achieve some combination of increasing investment returns, limiting portfolio volatility and managing liabilities down over time," says Greenwich consultant Dev Clifford. Among the increasingly popular products are liability-driven investment strategies, absolute return strategies, portable alpha and net-long approaches such as 120/20 and 130/30 strategies.
About a third of US plan sponsors told Greenwich Associates that they adopted new policies in response to the emerging regulatory environment, and another 30% said they planned to do the same over the next two years. Absolute return strategies rank the highest in pension funds' favour: 21% of plans have already implemented them and another 12% are thinking of doing it. Some 11% have adopted portable alpha strategies and 13% plan to do so, while 10% have chosen efficient portfolio strategies utilising derivatives or other synthetic instruments, and 9% are going to do the same. No less than 8% have reduced equities and increased fixed-income assets and 10% will do it soon, while 4% have decided to immunise liabilities and 10% plan to do it.
"Although the proportion of pension funds that have immunised liabilities remains low, it should be noted that the share of corporate funds that have immunised doubled from 3% in 2005 to 6% in 2006," says Greenwich consultant William Wechsler. "It is our belief that we are seeing the beginning of a trend that could have profound ramifications for defined benefit pensions - and by extension, the investment management industry - in years to come."
In addition, more and more pension funds are opting for hedge funds. Last year nearly a quarter of corporate plan sponsors and 23% of public plan sponsors said they invested in hedge funds, up from 21-22% in 2005. But General Motors chose a simpler way and last month announced an asset allocation shift of 20% from stocks to bonds for its DB plan.
"What this is intended to do is to reduce the expected volatility of asset returns in the plan's funded status, and frankly lower the probability of any future funding requirements," explained GM's chief financial officer, Fritz Henderson.
The allocation will be 52% in global bonds, 29% in global equity, 8% in real estate and 11% in alternative investments, while the expected return on assets for 2007 has been lowered to 8.5% from 9%.
Ultimately, corporate sponsors are looking at the future of their DB plans with more confidence. According to a survey by CFO Research Services, among 174 senior finance executives - 75% of whom were American - 70% said their companies are not likely to terminate some or all of their open DB plans and 61% said they are not likely to freeze them for everybody.
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