David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today’s episode is on corporate pensions and has been recorded for institutional and professional investors. I’m David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Michael Buchenholz, Head of US Pension Strategy in our institutional strategy and analytics group. Welcome to the Center for Investment Excellence.

Michael Buchenholz: Thanks. Thanks for having me David.

David Lebovitz: Of course.  For our listeners who missed our most recent episodes, all upcoming Center for Investment Excellence episodes will focus on current market volatility and how investors can best position themselves to withstand both current and future conditions.

Today we’ll be discussing how market volatility that resulted from COVID-19 is affecting the corporate pension plan space. We’ll discuss the trends that we’ve identified by analyzing 2019 data from the 100 largest corporate pension plans by assets and whether or not those trends are likely to persist throughout 2020.

So Mike, before we get into what’s been going on in markets over the past couple of months, let’s start by reviewing some of the trends that came out of your 2019 corporate pension peer analysis piece. At the start of 2019, funded status for this peers that was around 87.3% and by the end of the year and it only increased by that half a percentage point. Given the volatility that we saw, however, over the course of 2019, you know, these numbers clearly don’t tell the full story. Funded status actually fluctuated within a range of around seven percentage points during the course of last year.

So to start, can you walk us through some of the main drivers of that variability that we saw in funded status in 2019?

Michael Buchenholz: Sure. In our peer analysis paper we looked at the top 100 plans in terms of asset size to try and get a sense of the trends across asset allocation and risk transfer and pension strategy that are occurring during each year.

When we look at funded status, what we experienced was somewhat similar to 2018. So there is sort of this modest headline increase in funding status in 2018 year it’s about 1.5%, this year it’s about 50 basis points. But sort of underneath the hood when you look month-to-month, there was significant volatility and that’s all really just driven by market.

So when we look at 2019, what we see in the funded status trend is really sort of this horse race is what we call in the paper between equities and bonds. So, you know, over the year just about every asset class went up, but funded status kind of peaked around April and then takes going into May as equities fell behind bond returns. But, you know, you plot the relative performance and you basically get the funded status trend over the year.

So what we had is a very modest increase in funded status for the year, but surprisingly at the same time this kind of occurred against the backdrop of really amazing returns coming out of the market. So equities are up over 30% in terms of the S&P 500, but that was pretty much wiped out by a decline discount rate that are grinding slowly throughout the year down 100 basis points and that was actually looking back as far as we can tell the largest decrease in discount rates over a year on record, at least since pensions have been using AA corporate bond discount rates.

And to just put that in the context, what we’re experiencing now in about early March discount race for the year were down about 75, so not even as much as last year and then we kind of saw this huge sort of EKG looking spike and retrace where they went up 150 basis points then back down again.  And we’re actually right now kind of retracing the changes from 2018 in terms of where we are in the discount rate front.

But some of our major takeaways here are looking back not just the 2019, but kind of the longer time horizon across the past 10 years for this set of plans where that most plans beat their expect return of assets. So we found that about 85% of plans has beat their investment returns. You know, this is always a sort of hot topic and expected return assumptions have grinded lower across all different types of institutional investors every single year.

So that was good news and not surprisingly, 2019, the average return on plan assets was we calculated about 19%. So no one has an expected return assumption that high. So that certainly helps push some plans above the long-term trend. 

But when we look at returns relative to liabilities, we found that actually only about a third of pension plans have beat the liabilities. And so I think this is - should serve as sort of a wakeup call to those plans still investing while ignoring their liability and not taking a liability aware mindset. You know, we see that in 2019 where very good returns kind of didn’t really move the needle on funded status and it’s kind of a microcosm of the larger picture where if you don’t focus on beating the liabilities and just focus on beating your expected return, you may be achieving the smaller objective, but you’re missing the big picture because at the end of the day, funded status is what matters and these people will pay out those benefit payments to plan participants.

David Lebovitz: And actually Mike that brings me to my next question. One of the things you mentioned in your latest paper into the unknown is you expect the fallout from the COVID-19 outbreak to have both long and short term effects on plan sponsors. Will any part of the CARES Act help absorb some of the shock?  And perhaps more importantly, will it be enough?

Michael Buchenholz: Sure. So in this paper we looked at a couple things, I mean before even looking at potential and actual legislation changes. We wanted to look at what happened to our peer set and we estimated that those plans were down anywhere sort of between 5% and 15% in terms of funding status. What was interesting is actually looked at their performance in terms of the actual sort of stocks, the equity performance of the underlying companies and found that they perform significantly worse than the S&P 500 overall.

Now some of that could be idiosyncratic just because of the companies that have large pension plans or maybe more so, it’s the function of the sort of large tech companies driving returns now that don’t have legacy pension liabilities. But nonetheless that was interesting and kind of a reminder that the plan sponsors that have large pension plans and especially those with large public equity allocations, you know, that equity beta sort of flows through to the underlying plan sponsor and their stock price.

But when we think about the CARES Act, actually it doesn’t really help any of the plans themselves, not at least directly. So the legislative really we saw from the CARES Act for single-employer DB plans was the ability to defer contributions that were required to be paid during 2022 to January 1, 2021, as well as some relief on (AF) calculations which is essentially used to estimate or to determine if benefit restrictions are needed. So big picture there is that allows plans that have experienced a fungicide has hit to continue to pay long sums to workers, for example, which we know is very important for a lot of plan participants who are struggling financially now.

So deferring contributions to 2021 that sort of buys some time for plan sponsors who have taken a financial hit and need that liquidity and need that cash for other purposes, so that more helps the corporate sponsors. What was sort of more glaring was what was missing and a lot of what’s been asked for by a lot of lobbying groups and industry groups which is actual sort of legislative pension relief in terms of the calculation for contributions. And so we’ve seen a couple of proposals here from a number of groups falling into a couple of different camps.

One of those is extending the amortization for calculating contributions from say seven years which is the current to 15 years. So what that essentially does is it doesn’t change the onset of required contributions, but it makes them much smaller when you do have to pay that. We’ve also seen proposals to extend the corridor around discount rates. What that does? That would actually push the onset of required contributions farther out into the future. And of course, these two impacts combined would be the most powerful. But I think if one thing is sort of certain, we said this in the paper that (Ben Franklin) had said that death and taxes are the only certainty as well.

Pension legislative relief in the face of any type of market stress, it seems to be a certainty at least historically. So I think we see sort of a high probability that some of these changes will be adopted and will buy plan sponsors a bit more time.

But of course there is a bit of downside here as well which is that pushing out contributions and especially this year where we see the deferral contributions and actually as plan sponsors have published their 10-Qs and had earnings calls and published in many cases indicating that there are in fact many plan sponsors are taking this opportunity to defer contributions whether they required or ones that they had plans to make on a voluntary or discretionary basis.

So that means is that there is a larger sort of pull on net cash flows, so the pension system had already been aging as there’re more retirees, less actives, more frozen plans and that kind of tips the scales rather than having inflows every year from contributions there is more persistent and larger outflows and cutting out contributions is just going to sort of accelerate this trend here. And that has implications for asset allocation and the way plans are thinking about structuring their portfolios.

David Lebovitz: And I think that that’s really the key point that we want to kind of land on as part of our conversation today, we’ve talked a little bit about what happened last year and the impact that volatility across capital markets can have on a pensions funded status. We’ve talked a little bit about how the rules of engagement if you will may change here given the environment we currently find ourselves in. But to kind of wrap things up Mike, how should plan sponsors be thinking about adjusting their pension strategy and asset allocation not only given the current environment, but perhaps even with an eye on the way things may evolve over the next five, 10, 15 years, so on and so forth?

Michael Buchenholz: So just continuing the thoughts around the CARES Act and the impact on cash flows that results in increased need for income and more and more plan sponsors are thinking about how to find and source that income especially in an environment where many fixed income assets and especially Treasury bonds are not giving you that much healed. And so we think core real assets is a area that can be very helpful to plan sponsors giving them low equity beta and high income. So depends on funding sources, but selling public equities into core real assets can bring down funded status volatility and that’s something we’ve been talking about it for a while and increase income to facilitate benefit payments.

But on the other hand, for plan sponsors that are sort of at the low end of that 5% to 15% change year-to-date, using real assets as a substitute for fixed income can actually make a lot of sense and have a sort of minimal impact, but likely small increase and the funded status volatility, but get a big pickup on returns given the yield differential between some of these asset classes like infrastructure and transportation relative to Treasuries or high quality corporate bonds.

Another area that there’s been a lot of conversation about is rerisking and managing along your glide path. So there has been a lot of questions from plan sponsors about whether they should rerisk and when they should rerisk. And I think it’s interesting that this contribution deferral, but really this longer term potential relief that may further push out contributions gives plans an opportunity to address to (the both bullet) as pension relief was kind of coming to an end, there was a concern that funded status shocks like what we’ve experienced year-to-date would more quickly translate into actual contribution requirements.

But if we’re going to get an extension of pension relief then this gives plans the ability to kind of run with more funded status, also to run with more risk to help them close these funded status gaps.

Now in that same conversation, there is kind of coming back to active management especially in equities. We’ve seen a lot of plans really across all different types of institutional investors migrate some of their portfolio, at least on the equity side to passive. But given the dispersion in markets right now, we think that active management sort of right for a comeback if you will.

I think the last topic that we’ve had a lot of conversations about is diversifying hedge performance. So this is something that we have been talking about really for over a year as concerns buildup in traditional corporate credit hedge portfolios where we’ve seen concern around (unintelligible) and essentially got a small number of corporate issuers that are heavily concentrated across many pension hedge portfolios, especially as they get better funded.

Corporate spreads now have gone through sort of a wild rollercoaster, but they’re still wider than where they were year-to-date. So that may seem that there is an opportunity to add credit in hedge portfolios. And in small amounts, we think that could be prudence. But diversifiers and these are asset classes that give you long duration fixed income exposure, but different sources of risk in return like securitized asset classes, commercial mortgage obligations and CMBS, we think these asset classes make a lot of sense and really enhance the resiliency of hedge portfolios.

And then the question that (Pause) is well, why now, did you miss the boat because of the outperformance relative to credit in the first quarter? And we think the answer is no. All these concerns that we’ve been focused on in 2019 have only magnified. We’ve seen I think the largest issuance on record in Marsh and I just look at the numbers that came out, issuance was even higher in April. So companies continue to issue more debt. And then David, I think you follow closely earnings expectations and as they come in continue to fall. So the leverage and default expectations had increased, so the downgrade risk is high even in these high quality corporate bonds.

To summarize, we think that not only is it not too late for hedge portfolio diversification, we - it’s almost more important now than it has been in the past.

David Lebovitz: Excellent. I think it’s a really key point. Obviously a lot of different moving parts here, but Mike, thank you for taking some time today to help us make sense of all of this and more importantly, thanks for joining us on the Center for Investment Excellence.

Michael Buchenholz: Thanks, I had a great time.

David Lebovitz: Thank you for joining us today on JP Morgan Center for Investment Excellence. CFA Institute members are encouraged to self-document their continuing professional development activities in their online CE tracker. If you found our insight useful, you can find more episodes anywhere you listen to podcasts and on our Web site recorded on May 6, 2020.

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