With Markets Going Up, Why Does My Funded Status Keep Going Down? By: Erica HarperEA

It seems so long ago, but it was just March of 2000. Technology stocks were peaking, valuations were stretched and investors started to sell, bursting the dotcom bubble. With interest rates plummeting as well, defined benefit (DB) plan sponsors watched their funded status flip from surplus to deficit almost overnight. Over the course of the next eight years, the market recovered, again reaching all-time highs, interest rates stabilized and plan sponsors were once again blissfully ignorant about the future. Investment returns masked the requirement for contributions and plan sponsors were back on the holiday they enjoyed before the crash of 2000. Then Lehman Brothers became front page news, causing another plunge in pension plans’ funded status. Now, just four years later, the market is back. Here we go again…

As the saying goes, “Fool me once, shame on you; fool me twice, shame on me.” But a third time? Yet it is impossible not to get caught up in the run up, but is it worth the risk? As the market continues to go gangbusters, many pension plan sponsors are scratching their heads. If the market is going up, why is my funded status going down? The answer lies in the liabilities. 

Pension plan liabilities are typically measured based on high-quality corporate bond yields. Similar to bond prices, pension liabilities move in the opposite direction of interest rates and, as we’ve seen over the last few years, are highly sensitive to movements in these rates. Unfortunately, this interest rate risk is out of your control. But what about your investment risk?

Pension plan sponsors have traditionally directed money managers to invest their pension assets with the goal of maximizing returns within acceptable risk parameters. Success is measured by how the assets perform relative to certain benchmarks year over year. Seems like a reasonable objective to any investor. However, a pension plan is not any investor and its financial well-being is not driven by asset performance alone. Rather, the measure of financial success for a pension plan is its funded status – or the interplay between assets and liabilities. While asset risk – investing in equities over bonds – is a compensated risk (in other words, there is a payback for taking on the risk), interest rate fluctuations are considered uncompensated risks and should be avoided to the extent possible. This is what a liability-driven investing (LDI) approach strives to do: mitigate the volatility of funded status due to interest rate risk while also limiting market risk.

The concept of LDI was first introduced in the UK over 50 years ago but did not start to really gain traction in the US until the early 2000s. Generally speaking, an LDI strategy looks at pension plan asset allocation from the perspective of total plan risk and return and includes the plan’s liability as a risk factor in setting the allocation. Regardless of how the assets perform, the liability can still fluctuate with changes in interest rates, directly affecting the funded status. In fact, the interest rate risk often outweighs the asset risk. Let’s take a look at what happened in 2012 to help illustrate this (fig. A):
Plan A was fully frozen on December 31, 2010. As of December 31, 2011, Plan A had assets of $100 million and liabilities of $120 million, resulting in a funded status of 83%. Plan A’s portfolio was invested 60% in stocks and 40% in fixed income and had a return of 11.5% during 2012. Separately, plan assets increased by $3 million due to a contribution and decreased by $4 million in benefit payments to retirees. In total, the plan assets increased by 10.5%. During the same time period, interest rates decreased 55 basis points, resulting in an 11.3% increase in liability. Including the interest cost on past service liability offset by benefit payments, the total plan liability increased by 12.1%. At the end of 2012, despite very positive market returns, the plan’s funded status actually decreased to 82%. Remember what this plan looked like in the perfect storm of 2008? 

This phenomenon generally occurs when plan assets are invested in an asset-only framework and the investments have a shorter duration than plan liabilities, creating a mismatch and increasing interest rate risk. By increasing the duration of the portfolio, the uncompensated risk can be diminished. As a starting point, this may simply mean lengthening the duration of your current fixed income portfolio.
Given the current underfunding of most pension plans, the idea is not to jump into an LDI strategy tomorrow, but to formulate a plan that gradually moves assets from return-seeking to liability-hedging as funded status improves. This requires a thoughtful approach orchestrated by the plan sponsor integrating both the actuary and the investment manager. With the volatility in the markets, this analysis cannot occur once a year on a plan’s valuation date. It requires close coordination and constant monitoring to capture market opportunities and movements in interest rates. When the market is going strong, it is so easy to forget. But as history has shown, anything can happen…and then it’s deja-vu all over again.

 
Erica Harper

Erica Harper is a founding partner of Harper Danesh LLC, an actuarial consulting and retirement planning services firm located in Rochester, NY, with particular expertise consulting on defined benefit and defined contribution plans for a wide range of clients. Erica lives in Pittsford, New York with...

More about Erica Harper
Sign up for our Newsletter

More Articles From This Issue

Sign up for our Newsletter