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Aon Retirement and Investment Blog

US Corporate Pensions Year in Review: 2016 Trends and 2017 Opportunities

2016 Year in Review
 
US Corporate Pension Plans ended 2016 in roughly the same funding position as the beginning of the year according to Aon Hewitt’s Pension Risk Tracker[1]. However, US pension plans were not immune from the market volatility and geopolitical events of 2016, as shown in Exhibit 1.




The surprising result of the UK referendum to leave the European Union led investors to rush toward safer assets like US Treasuries and pushed rates to near-historic lows. US pension plan funded ratios plunged almost immediately after the Brexit vote, but modestly rebounded shortly after the referendum. Pension funding levels remained low for several months until the surprise result of the US presidential election, which brought new expectations for fiscal stimulus, higher inflation, and growing budget deficits. This immediately sparked a rally in equity markets and accelerated a rise in bond yields that began mid-year. As a result, pension plans largely recovered losses experienced earlier in the year.
 
Individual pension fund performance could have varied significantly depending on asset allocation and risk management strategies used. For example, plan sponsors with certain equity diversifiers in their return-seeking portfolios and long duration credit bonds to hedge their liabilities may have fared better, as shown in Exhibit 2.



Market Outlook
 
The US economy showed signs of improvement during the latter half of 2016 and now unemployment measures have reached pre-financial crisis levels. Considering this along with fiscal stimulus expected from the Trump administration, AHIC’s Global Asset Allocation Team believes the risk of higher inflation has increased, which may lead to sharper interest rate increases. However, we believe the risk of higher interest rates over a longer (3-5 year) period is largely captured in market pricing via the term structure, and therefore generally prefer long duration bonds over shorter duration bonds for pension liability-hedging portfolios.

Our Global Asset Allocation Team is generally region-agnostic when it comes to the equity market. We believe that US equity returns will likely remain handcuffed by high valuations and favorable market reactions reflected in current pricing. Overseas, we believe attractive valuations and an improved growth outlook are offset by continued non-market risks in Europe, the prospect of higher interest rates, and a stronger US dollar. We believe emerging markets continue to offer value and improving fundamentals, but we remain cautious due to the volatility of these markets.
 
Pension Risk Management Strategy Implications
 
Based on the above, we see several implications on pension risk management strategies.
 
Investment Strategy
 
Pension plan sponsors should optimize their investment strategies based on their organizational objectives and market views. We believe a strategic liability-hedging portfolio, coupled with a well-diversified return-seeking portfolio, may enable plan sponsors to effectively manage their pension risks.
 
We believe the goal of the liability-hedging portfolio should be to hedge liability interest rate, credit spread, and yield curve risks. This typically involves the use of long duration investment grade fixed income, but may be enhanced with the inclusion of government bonds, active management of credit, and/or the use of derivatives to fine-tune the hedging program.
 
We believe the goal of the return-seeking portfolio should be to outperform liabilities while mitigating downside risk. The key to accomplishing this goal is diversification. While globally diversified public equities are the primary drivers of excess returns over the liabilities, the additions of non-investment grade credit, real assets, and other strategies that take advantage of manager skill may provide enhanced return and reduced risk.

Dynamic investment strategies are critical to pension risk management in volatile financial markets. Glide Paths can be used to manage risky asset exposure based on funding levels. Hedge Paths can be used to phase into longer duration fixed income as interest rates rise. In addition, plan sponsors may wish to pursue credit management strategies in 2017. A dynamic “Credit Path” strategy provides a structured way to vary the allocation between credit and government debt within the liability-hedging portfolio with the funded ratio and the attractiveness of credit vs. government debt based on spread levels and other factors, such as liquidity.
 
Settlement Strategy
 
We expect that settlement activities such as retiree lift-outs and lump sum windows will continue to be attractive for sponsors looking to reduce PBGC premiums and the size and risk of their pension obligations. This may be the last call for lump sum windows, as plan sponsors can benefit by settling certain liabilities in 2017 before the IRS implements updated mortality tables which may increase funding requirements and PBGC premiums as early as 2018. In addition, many plan sponsors expect to reduce their retiree headcount through purchasing annuities from insurers, in particular for retirees with small benefit amounts, again with the primary benefit of reducing PBGC premiums.
 
Funding Strategy
 
We expect rising PBGC premium rates on unfunded liabilities and the potential for corporate tax reform to continue to drive interest in pre-funding strategies in 2017, including borrowing to fund existing pension deficits. We recently addressed the implications of the new potential tax regime on pension funding strategies in a blog post entitled “Potential U.S. Corporate Tax Reform Presents Prefunding Opportunity in 2016.”
 
The Final Word– Opportunities Abound in 2017
 
Despite financial statement headlines that show funded ratios at the end of 2016 largely on par with the beginning of the year, 2016 was marked by significant volatility in private sector U.S. pension funds. A deeper dive revealed opportunities for pension plan sponsors to continue to expand their risk management strategies in 2017 to include: strategic liability-hedging portfolios, diversified return-seeking portfolios, dynamic investment strategies, credit management strategies, liability settlement strategies, and opportunistic plan funding.
 
Phil Kivarkis, FSA, CFA is the US Director of Investment Policy Services, based in Lincolnshire, IL.
Richard Parker FSA, EA is a senior investment consultant in the Investment Policy Services group, based in Denver, CO.
Ben Sumarnkant ASA, EA is an actuary in Aon Hewitt’s US Retirement and Investment practice, based in New York, NY.
 
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[1] Aon Hewitt’s Pension Risk Tracker tracks the daily funded status of 350 S&P 500 companies with defined benefit pension plans. The Pension Risk Tracker can be accessed by visiting https:\\pensionrisktracker.aon.com
Content prepared for U.S. subscribers, but available to interested subscribers of other regions.

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