Ever since Congress passed the Pension Protection Act four years ago this month, corporate pension-plan sponsors have been slowly but surely moving toward less-risky asset allocations in order to maintain compliance with the law’s stringent funding requirements. For many, that has meant pursuing a liability-driven investment (LDI) strategy, using long-term bonds or a series of swaps in order to make the duration of assets match up with the expected maturation of liabilities.
The biggest drawback to such an approach is that it generally caps upside along with volatility, a sacrifice some companies were glad to make while equity markets were on a roller-coaster ride. In rocky 2008, for example, users of an LDI strategy could have seen a small gain, while those with a more-traditional allocation would have seen a nearly 25% loss, according to hypothetical portfolios constructed by Towers Watson.
In the past year or so, however, experts say they have seen companies becoming more reluctant to press forward with LDI strategies, for a variety of reasons.
For one, the equity markets’ relatively strong performance has created a siren call for plan sponsors that previously saw big losses. “Companies that are underfunded are more likely to stay with equities in hopes of investing their way out” of the situation, assuming they’re not in such poor condition that they can’t afford to take the risk, says John Ehrhardt, a principal with Milliman and author of its annual pension funding survey.
Milliman’s study this year (based on last year’s 10-Ks) hints at this. In 2009 pension equity allocations increased slightly, from an average of 44% to 46%, after several years of sharp declines. Some companies even made big increases in the category. Baxter International, whose pension plan was about 71% funded at the end of last year, boosted its equity allocation up to 69%, from 50% the year before, according to Milliman data.
Others are looking at trends in the bond market. “A substantial number of the people we talk to about implementing LDI strategies are concerned about interest rates going higher,” which would potentially make bond prices more attractive in the future than now, says Thomas Meyers, head of North American distribution at Chicago-based pension investment adviser Legal & General Investment Management America (LGIMA). “A smaller percentage are thoughtful about the general level of credit spreads,” which could affect future bond durations, he adds.
At some companies, the picture is even more nuanced. Bob Hunkeler, vice president of investments at International Paper, says his company has been steadily lowering its equity exposure, from 62% of its pension portfolio to 43% currently, with some increase in alternative investments as well as in fixed income. However, the company also unwound its LDI strategy, which largely involved hedging its liabilities through swaps, in the fall of 2008 as swap rates began to diverge from the corporate bond discount rates that factor into the calculation of pension liabilities. “We’re looking for those two rates to come back together before we get back in,” he says.