May 31, 2014
The first quarter of 2014 shows just how quickly pension funding can change when liabilities are left unhedged. After seeing record A/L Watch year-over-year funding ratio improvements in 2013, there was a reasonable expectation that 2014 could see volatility. January did not fail to deliver said volatility, with an equity market pullback and liability rally. In the month of January alone, the model asset allocation was down –1.61% and Ryan Labs PPA liabilities were up +3.22%. This resulted in a funding ratio decrease of 4 percentage points for the month. February would trudge ahead with stronger asset returns, and also stronger liability returns. At the end of February, the RL model asset allocation was up +1.36%, while RL PPA liabilities were up +4.94%. The quarter ended with liabilities outperforming assets by 4.08%, resulting in funding ratios declining to 82% , down from 85%, to finish up the quarter.
According to the PBGC, the first private pension plan in America was started in 1875 by American Express. This was two years after the Panic of 1873, which was the start of a five-year depression that lasted until 1879. 135 years after the depression lifted in 1879, pension plans are still forced to measure and weigh the impact that macroeconomic factors and volatility will have on a their investments. Asset allocation decisions still have to be made in a manner that balances risk and return. The volatility and left-tail risk that surfaced in the first quarter of 2014 brings with it uncertainty about what will happen during the remainder of 2014. Q1 could represent history repeating itself with a major pullback, or returns can tread water in a pool of uncertainty for the remainder of the year, or Q1 could be a brief pullback followed by continued strong gains in both assets and pension funding. Nothing is for certain.
While at times it feels like the Pension Protection Act of 2006, FAS 158, IAS 19, glide paths, and pension risk management have been around since American Express started their pension plan in 1875, the reality is that there are still pension plans that are focusing on maximizing returns with little regard for left-tail risk. For those plan sponsors that are balance sheet rich and can support this volatility, return seeking strategies are not a problem. If need be, they can write a check to make up for negative market returns. However, for those plans that are balance sheet sensitive, that are trying to minimize funding volatility on an ongoing basis, that are working to implement termination strategies, or perhaps are restructuring their plan designs to ensure long term sustainability, the type of funding ratio volatility that exists on Page 3 of A/L Watch can have serious ramifications to them.
While a year like 2013 can make investors hope for continued excess outperformance, this cannot be guaranteed. Keeping asset allocation risk management characteristics in line with risk capacity and risk budgeting goals is one way to guarantee that if negative volatility does occur, there is additional protection that does not exist in the asset-only investment framework. The degree to which pension funding risk is and can be reduced, is up to each individual plan sponsor.