With improvement in funded statuses, it is a good time to lock in yields for asset / liability matched pension funds, concludes Citi in its recent report.
Erin Lyons and Swati Verma of Citi point out that when pensions are undertaking asset/liability matching, movement in underlying assets would become irrelevant.
Drop in yields
Focusing on corporate pension plans, Citi analysts point out that pensions manage assets to eventually pay their beneficiaries. For this purpose, corporates discount their liabilities using a market-based rate, such as the Citigroup Pension Liability Index, that usually tracks the AAA-rated corporate index. The following graph highlights how low rates have challenged pension plans:
The analysts believe with fall in asset values coupled with lower yields, managing pensions proved to be tough during the past five years.
As we pointed out earlier, according to Milliman 2013 Public Pension Funding Study, the median interest rate used by public pension plans dropped from 8% to 7.75%.
Improved funded status
Erin Lyons and Swati Verma of Citi point out that such a drop in asset values and yields has boosted benefit obligations and funded statuses hit all-time lows. The following graph illustrates the funding status of the typical plan:
Citi analysts point out that the difficult scenario in the past five years has created volatility in cash flows, since corporates are required to make cash contributions to underfunded plans. This has also hampered credit profiles as many analysts and rating agencies consider underfunded amounts as debt. The analysts note a plan is required to fund 1/7 of its shortfall each year.
Tracking Milliman (Pension) Funding Index, Citi analysts conclude that funded status have improved by nearly 15 percentage points since year-end. While asset returns have accounted for about 40% of the improvement, lower benefit obligations attributed the remaining 60%.
Shift focus to matching assets/liabilities
Citi analysts point out that with improved funded statuses, the focus should be shifted back to matching assets / liabilities.
The analysts believe now is a good time to make this switch, even if the asset value could fall potentially. Once such asset/liability matching is done, the movement of underlying assets would not have much impact. For instance, Citi analysts point out that if yields go back up, the liability side of the equation is also revalued. However, the analysts believe if rates go up, obligations would fall.
The Citi analysts point out that the median funded rate was 76% at the beginning of the year, and funds would essentially lock in a 24% underfunded status. Hence shifting to an asset/liability matched book didn’t make sense for several funds.
However, with the expected funded status currently trending north of 90%, Citi analysts believe more managers want to lock in, allowing them to become agnostic to rates and requiring they only try to make up the 10% funding shortfall.
Citi analysts anticipate several CIOs would be willing to de-risk their portfolios after they tried for years to manage the volatility in valuations and funded statuses. As such, the analysts anticipate 20 year+ paper issued by highly rated credits to be in demand, both in the primary and secondary markets.
