Topical Commentary Pension Funds on a Roller Coaster Ride January 2014 Pension funds may have had their best year ever in 2013, improving $303 billion in aggregate among S&P 500 companies. This follows several years of declining assets and falling funding statuses. How did pension funds get in such a perilous position? What turned in their favor in 2013? And is another good year a possibility? Over the past 30 years, pension funds have endured a long period of falling interest rates. Peaking around 14% in the 1980s, the 10-year Treasury yield had fallen below 2% by 2013. Conversely, stocks and bonds have had relatively strong performance over the long term, despite some challenging years (Chart 1). Chart 1 Long-Term Interest Rates and Equity Market Performance Source: Bloomberg L.P., PNC It seems as though falling interest rates had the effect of causing the present-day valuation of pension plan liabilities to climb. Early in the 30-year period when interest rates were high (and the present-value of long-term liabilities was therefore low), pension funds enjoyed funding surpluses. Then, in the new millennium, market losses and the sustained period of the Federal Reserve (Fed)- aided low-interest-rate environment began to take a toll. As measured by the Millman 100 Pension Funding Index (PFI), the average funding status of defined benefit plans declined from a surplus of 130% in 2000 to a low of 70% in 2012. This resulted in a much more problematic environment for managing pension funds, and in some cases, resulted in plan sponsors deciding to freeze plan benefits.
Long-term interest rates have moved north since late May 2013, when Fed Chairman Ben Bernanke first hinted that the Fed would taper bond purchases shortly. At the start of 2013, 10-year Treasuries were at 1.8%; one year later, they are at 2.8%. Since late May 2013, there has been an increase in rates across many developed markets. To be clear, despite the commencement of the taper, the Fed governors have reaffirmed the Fed s commitment to leaving rates low at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than half a percentage point above the [Federal Open Market] Committee s 2% longer-run goal, and longer-term inflation expectations continue to be well anchored, according to the Fed s January 29, 2014, press release. Firms with long-duration pension liabilities tend to benefit from higher interest rates, as this would likely result in lower current obligations. Also, higher rates could benefit plans taking on interest rate risk. Rising rate scenarios include the following: If a plan s liabilities are discounted using a market curve, rising rates reduce the present value of the liabilities, potentially improving the plan s funding status. Rising rates directly affect bonds held in a portfolio; that is, bond prices will fall, which could hurt the funding status. Other asset classes may be indirectly affected by rising rates. Chart 2 Citigroup Pension Discount Curve Source: Society of Actuaries Lower Pension Liabilities Equal Healthier Plans Pension plans differ in their asset allocation, funding status, and relative durations of their assets and liabilities. Though some pension plans have switched to a liability-driven investment (LDI) strategy, which reduces interest rate risk, traditionally the bulk of pension plans are structured as long-asset, short-liability portfolios. Pension obligations, that is, the present value of money a firm owes its workers, are an ever-moving calculation. When rates rise, the discount applied to today s money also increases; thus, the amount of money needed to meet the future liability actually shrinks. Historically, higher interest rates have resulted in higher discount rates. Typically, discount rates are tied to yields on high-grade corporate bonds or, in some cases, government bonds. Each pension plan typically uses its own discount rate, but the Citigroup Pension Discount Curve, used by the Society of Actuaries Pension Section Council, can be used as a guide. The curve is up almost 100 basis points since the end of 2012 and stands at its highest level since August 2011. Given these results, we would expect the average discount rates used by S&P 500 companies pensions to rise from their record low of 3.9% in 2012 (Chart 2). Final 2013 numbers should be available in first-quarter 2014. Higher discount rates generally have the effect of shrinking pension obligations, all else being equal, likely leading to a healthier pension plan. The magnitude of improvement really depends on the plan s sensitivity to rates and how well its assets perform, among other factors. 2 January 2014
Internal Revenue Service rules determine how much firms have to actually contribute toward their pension plans based on mandated discount rates. In 2012, in order to provide some relief to pensions faced with historically low rates, Congress allowed plans to use 25-year average corporate bond price data rather than 2-year average data to calculate contributions. This helped reduce the negative effect of the extended low-interest-rate environment. Impact on Funding Even as rising interest rates temper returns on fixed-income investments, pension plans, among other long-term liabilities held by corporations, seem to be benefiting. According to estimates from Mercer human resource consultants, these higher rates and to a lesser extent the recent strength of equity markets have brought the average funding ratio the percentage of liabilities covered by assets of S&P 500 companies to 95% at the end of 2013, a 21-percentage-point increase over the course of the year and the highest level since May 2008. Similar improvements were experienced among the smaller S&P 500 group (Table 1). This increase in the average funding status appears to be more a result of rising rates reducing future liabilities than an increase in underlying assets, although the latter has made significant contributions as well. Pension plans use a discount rate to anticipate their expected future expenses. Rising Table 1 Estimated Pension Tailwind by Sector, S&P 500 Estimated Pretax Pension Cost, Pension Tailwind as a Millions of Dollars Percentage of 2014 Sector 2013 2014 Change Consensus Earnings Estimate Consumer Discretionary 5,748 3,976-1,772 1.1% Consumer Staples 3,442 1,594-1,848 1.3 Energy 6,976 4,420-2,556 1.2 Financials 3,766 864-2,902 0.9 Health Care 4,111 2,030-2,081 1.1 Industrials 17,674 9,612-8,062 5.0 Information Technology 3,230 9-3,221 0.7 Materials 4,493 2,368-2,125 4.0 Telecommunication Services -97-168 -71 0.2 Utilities 5,205 2,334-2,871 5.8 S&P 500 53,458 27,037-26,421 1.6 Source: ISI Financial Group, PNC rates help reduce the present value of these future liabilities and therefore can help improve the plan s funding status. Pension funding looks to be stable, in our opinion, and in many cases improving, a change from recent years (discussed in depth in our thirdquarter 2013 Investment Strategy Quarterly, Defined Benefit Pensions: Addressing Underfunding). In 2013, ISI Financial Group, Inc., estimated that as rates rose, pension funding for the S&P 500 companies improved $303 billion in aggregate, from about $435 billion underfunded (78% funded) at the end of 2012 to $132 billion underfunded (93% funded) at the end of 2013 possibly the largest single-year improvement ever. Higher rates have not been a magic fix, however; many plans remain underfunded. ISI estimates that only one in four pension funds are fully funded or better. We believe stronger asset performance, increased 3
contributions, and still-higher interest rates could help in this matter. Fortunately, with interest rates expected to rise further over the coming years, in conjunction with the recovering national economy, we expect that funding statuses will likely improve from their current levels. But there are risks, and a corporation s funding status can be volatile in some cases: The average funding status among S&P 1500 companies pensions plans was 91% in June 2011, but it fell to 77% within two months as intensifications in the European debt crisis and U.S. debt ceiling debates brought down interest rates. Any unexpected retrenchment in interest rates could undo part, or even all, of recent advancements, in our view. The ongoing shift among many pension plans to an LDI strategy could mitigate the fallout from changes in interest rates. Pension Impact Varies Among Plans Pension plans generally benefit from higher rates, but the mix of holdings affects how much of a boon rising rates could be. Each plan is unique, and a plan s sensitivity to interest rates will usually depend on its asset allocation and the relative durations of its liabilities and fixed-income assets, among other factors (Charts 3 and 4). Those with the greatest interest rate risk, that is, those with the greatest duration, appear to be benefiting the most. Most pension plans do not fully disclose their investments beyond general asset allocations, making it generally difficult to fully anticipate the effect of changes in interest rates on individual plans. We can, however, draw some general conclusions. Even modest changes in interest rates can have profound effects on liabilities. For example, in its February 2013 10-K, United States Steel Corporation (X) wrote that a 1-percentage-point increase in discount rates would reduce its pension plan obligations by $1.4 billion, which at the time accounted for more than a tenth of existing pension liabilities. We believe shrinking pension liabilities such as these suggest there may be some improvement in earnings and guidance for many companies over the next few quarters. Chart 3 U.S. Pensions: Asset Allocation of Model Plans Public Chart 4 U.S. Pensions: Asset Allocation of Model Plans Private Source: MSCI, PNC Source: MSCI, PNC 4 January 2014
At the same time, shrinking liabilities typically free up cash, so some companies may be able to pay down debt or make other investments. Take, for example, Ford Motor Company (F, Dividend Focus (D)). The gains of the past year sliced Ford s funding shortfall almost in half, and the company announced it was cutting 2014 pension contributions from as high as $3 billion to as low as $1 billion, potentially freeing up large amounts of cash for other operations. The positive effects of rising interest rates, combined with a stronger stock market, will vary based on the individual pension plan, given maturity profiles, percentage of workers versus retirees, and differing assumptions. According to research from ISI, the average duration of pension obligations is between 8 and 15 years. For a typical pension plan with a duration of 12 years, for example, the near-100-basis-point increase in the discount rate pushed liabilities down about 12%, according to Mercer; those plans with greater durations report even larger declines. These healthier plans should also provide a boost on income statements through lower pension costs. Pension liabilities tend to lag behind funding status (Chart 5), and therefore we believe pension costs are likely to fall this year. ISI estimates that pension costs will fall nearly 30% in total for S&P 500 companies. Further, according to a Credit Suisse study, rising rates this year should provide a tailwind heading into next year. The firm estimates corporate pensions will be 10% better funded on average in 2014. Chart 5 Estimated S&P 500 Pension Liabilities and Funding Status Pace of Progress Will Slow While we do expect funding ratios to further improve in 2014, the pace of improvement will likely slow from its current rate. Pensions will likely continue to be supported by rising interest rates and an improving stock market. But we expect the advancement in interest rates in 2014 to be only about half that seen in 2013, with even more modest gains in 2015 and 2016. This suggests less of an increase in the discount rates used by pension plans. Further, we do not expect the S&P 500 to replicate its stellar performance last year, and this will likely limit appreciation of pension plans assets. Source: ISI Financial Group There are other obstacles as well. Beginning in 2014 and continuing over the next few years, pension expenses are expected to rise. Pension Benefit Guaranty Corporation premiums will steadily rise over the coming years. By 2016, flat rate premiums will likely increase by nearly 50%, while variable rate premiums (which are much smaller) will almost triple from their current levels, in our opinion. At the same time, the Society of Actuaries will release new mortality tables sometime this year, which are expected to reflect longer life spans and lower risks of death at any given age. The ISI expects this change alone could increase pension obligations by as much as 10%. We believe such a large increase in liabilities could easily offset a significant share of any potential gains in falling present-day liabilities or asset increases. 5
Finally, changing behavior may also temper progress. We believe some pension managers may try to lock in the gains of the past year and shift some assets from equities to fixed income. Fed data show U.S. pensions plans shifted out of equities and into bonds in the third quarter at the fastest rate since 2008. Ford Motor Company is increasing its bond allocation to 80% of total pension assets in 2012, up from 55% in 2012. In our opinion, if the stock market has another stellar year, shifts like these could limit the equities positive effects on funding statuses. Conclusion It looks as if pensions are almost out of the woods, in our view, though the journey has been rough. Starting about a decade ago, the Fed s low interest rate policies pushed down the discount rate used to calculate a pension s present-day liabilities. As a result, the funding statuses of most pension plans soured and, in aggregate, fell to near-record lows by 2012. But the environment quickly changed in 2013, as rising interest rates combined with a stellar year for the stock market helped revive pension plans. In the aggregate, pension plans are nearing 100% funded, a level unfathomable just 18 months ago. But there is progress still to be made. Unfortunately, while plans are expected to progress over the coming year, we do not think the pace of improvement will match that seen in 2013. Asset allocation among pension funds is a strong component of how interest rates and market moves affect a plan. Differing percentage allocations to equity and fixed income play a role. Within each asset allocation, tactical allocations also affect sensitivity. In short, pension plans that have taken on the most interest rate risk by mismatching assets versus liabilities have likely seen the biggest benefits because obligations are shrinking as assets grow. Hedging would likely have inhibited the benefits. Despite the rise in rates this year, we expect long-term interest rates to remain at low levels relative to historical trends. This trend will likely persist for many years. While rates have risen, pension fund managers should be aware that financial repression is likely to stick around for a while. The PNC Financial Services Group, Inc. ( PNC ) uses the name PNC Institutional Investments to provide investment management and fiduciary services, FDIC-insured banking products and services and lending of funds through its subsidiary, PNC Bank, National Association, which is a Member FDIC. PNC does not provide legal, tax or accounting advice. These materials are furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation or particular needs of any specific person. Use of these materials is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading these materials should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in these materials was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in these materials and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in these materials nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax or accounting advice. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal. "PNC Institutional Investments" are registered trademarks of The PNC Financial Services Group, Inc. 2014 The PNC Financial Services Group, Inc. All rights reserved.