Controlling Funded Status Volatility Top Priority Among Pension Plan Sponsors

Of the poll participants identifying this as a top focus for 2012, nearly three-quarters (70%) said it is at least a “high priority,” with almost half (43%) of those saying it is an “extremely high priority.” Not far behind, plan sponsors identified the need to improve the funded status of their pension plans as the second most important priority this year.

“Market swings and low interest rates have really taken a toll on the funded status of pension plans over the past few years,” said Jon Waite, director, investment management advice and chief actuary, SEI’s Institutional Group. “Many plan sponsors now face the burden of making substantial contributions to their plans in order to meet funding requirements. As markets continue to be volatile, plan sponsors continue to pursue sophisticated risk management strategies designed to better control volatility of the funded status of their pension plans.”

According to the poll results, the top 10 priorities for 2012 are:

1.  Controlling funded status volatility. For the third consecutive year, plan sponsors ranked better controlling funded status volatility as their organization’s top investment priority for the upcoming year. Global market swings and low interest rates have greatly impacted the funded status of corporate defined benefit plans over the past few years. These wide swings are becoming increasingly less predictable, and that volatility is cause for concern. As pension assets and liabilities have become a more prominent part of organizational financial statements, the need to accurately estimate financial risks presented by the pension continues to increase. Plan sponsors are seeking solutions that hedge against risk and volatility while protecting any improvements in funded status. As a result, of those poll participants identifying this as a priority for 2012, almost three-quarters (70%) said it is at least a “high priority” for their organizations, with almost half (43%) of those saying it is an “extremely high priority.”

2.  Improving plan’s funded status. According to recent reports, the average funded ratio of U.S. corporate pension plans dropped to 72.4% in December 2011, hovering just above the historic low of 70.5% set in May 2003. The funded status decline was primarily due to higher liabilities caused by a decrease in corporate bond interest rates. With interest rates expected to remain low, many plan sponsors will be forced to contribute to their pension plans this year in order to meet Pension Protection Act (PPA) funding requirements. These contributions directly impact corporate budgets, cash flows, and overall finances, leading poll participants to rank this priority slightly higher in 2012 than in 2011. Of those plan sponsors identifying the need to develop strategies to improve plan funded status as a priority, more than half (69%) said it is at least a “high priority.”

3.  Managing duration moving forward.With pension volatility and funded status top focuses for plan sponsors this year, it makes sense that managing duration falls close behind in importance. Duration measures a change in value for both assets and liabilities based on interest rate movements. A mismatch between the duration of a plan’s assets and the duration of a plan’s liabilities can result in significant swings in a plan’s funded status. To reduce this volatility, one of the main objectives of a liability-driven investing (LDI) strategy is to more closely match the duration of these two. More than half (52%) of plan sponsors selecting this priority said it is at least a “high priority” this year.

4.  Implementing a Liability-Driven Investing (LDI) approach using long-duration bonds. Because managing the funded ratio of a pension plan has become a higher priority than the absolute return of pension plan assets, many plan sponsors are utilizing an LDI strategy. A global Quick Poll conducted at the end of 2011 found that 63% of corporate pension plan sponsors now use an LDI strategy with almost three-quarters (74%) incorporating the use of long-duration bonds as part of this approach. Long-duration bonds remain a popular investment choice in hedging against risk because they closely mimic liabilities, increasing in value as interest rates drop. In a continued low-interest-rate environment, more than half (55%) of poll participants identifying the need to implement an LDI approach using long-duration bonds said this is at least a “high priority” for their organization.

5.  Providing senior management or board with a long-term pension strategy. Underfunded pension plans continue to have a direct impact on corporate balance sheets and draw scrutiny from investors, creditors, analysts and the public. Senior management and board members are placing increased focus on the development of long-term pension strategies to better align investment decisions with overall corporate finances. Almost half (48%) of poll participants indicating a need to provide a long-term pension strategy to senior management and board members as a priority said it is at least a “high priority” this year.

6.  Stress-testing the portfolio to gauge its ability to withstand extreme macroeconomic environments.  While no guarantee against loss, stress tests allow plan sponsors to evaluate the performance of their current portfolios under potential market conditions. Stress-testing often reveals a lack of diversity within the portfolio, which could have a negative impact if sudden market changes occur. By stress-testing portfolios, plan sponsors are able to identify risks sooner and adjust investment decisions to better protect their portfolios. Almost half (47%) of poll respondents who identified this as a priority said it is at the least a “high priority.”

7.  Conducting an asset-liability study. As discussed, disconnection between pension plan assets and liabilities can cause increased funded status volatility. Asset-liability studies are conducted by actuarial and investment experts to provide plan sponsors with a sophisticated analysis of the two. Most studies include actuarial valuation and selection of assumptions, risk analysis, asset-liability projection analysis and proposed investment solutions, all of which help plan sponsors in creating investment and plan management strategies that improve funded status and mitigate overall risk. These complex studies are typically conducted every few years, but volatile markets have increased the frequency of these reviews; 35% of poll participants selecting an asset-liability study as a top priority said it is at least a “high priority” this year.

8.  Implementing an asset allocation process aimed at exploiting shorter-term market inefficiencies to add return and/or mitigate risk. A new addition to the list the year, this priority indicates an increased desire among plan sponsors to react quickly and nimbly to market situations in order to take advantage of short-term opportunities. Having an investment process in place, such as outsourcing a portion of the portfolio to a fiduciary manager, can increase the ability to react to short- term markets in order to increase return and mitigate loss. Of those poll participants who said such a strategy is a priority for 2012, more than one-quarter (29%) said it is at least a “high priority.” This priority replaces last year’s priority to “make a plan design change.”

9.  Changing funding policies and timelines. Funding-status volatility and increased contributions have prompted poll participants to rank the development of funding policies and timelines as a top priority again this year. Plan sponsors are developing more strategic funding policies in hopes of better managing future plan costs, establishing a consistent contribution schedule, and developing risk management strategies. One-quarter (25%) of plan sponsors ranking this as a priority said it is at least a “high priority” for the upcoming year.

10.  Defining fiduciary responsibilities for trustees and investment consultants .According to the Employee Retirement Income Security Act (ERISA), pension plan fiduciaries are responsible for fulfilling four key areas: acting in the sole interest of plan participants and beneficiaries; following the “prudent expert” rule, or acting as an investment expert might; ensuring investments are diversified to minimize risk of loss; and adhering to the terms governing the plan. Because failure to meet these standards can result in significant repercussions, plan sponsors need to identify how fiduciary responsibilities are being met and by whom, whether it be internal staff, a consultant, or an outsourced fiduciary partner. Almost one-quarter (23%) of those identifying this as a priority said it is at least a “high priority” for their organizations in 2012.

A complete summary of the poll is available by e-mailing seiresearch@seic.com.

The Quick Poll was conducted in January among 50 executives overseeing U.S. corporate defined benefit plans, ranging from $25 million to $10 billion in assets, none of which were Institutional clients of SEI.