July 31, 2015
The S&P 500 is down for the quarter. Bailout related austerity debates brought Greece to the brink of their membership in the European Union. Fears in the bond markets have seen spreads widen and yields rise. Interest rate uncertainty permeates the economic landscape. Uncertainty exists throughout the investing arena. Even with this negativity rearing its head in the markets, PPA funding ratios showed significant improvements over the past quarter, and glide path triggers have been hit.
While these various market events have an ominous undertone, their impact to defined pension plans have been the exact opposite. Rising yields and rising credit spreads have seen RL PPA liabilities fall by –9.19%, just in this past quarter. With the asset allocation model nominally down –0.59% for the quarter, there has been an outperformance of assets versus liabilities by +8.60%. This has resulted in funding ratios increasing for the quarter by approximately 8%, from 78% to 86%.
Over the past five years, the S&P 500 has continually climbed higher and higher. At the end of March 2009, the S&P 500 closed at 683.38. The index closed June of 2015 at 2063.11, increasing over three times. Simultaneously, RL PPA yields are off of their 2012 lows of 2.81%, and now sit at 3.73%. This is the highest yield that the RL PPA index has seen since the end of 2011. As the S&P 500 now enters its sixth year of a meaningful rally and RL PPA yields are at four year highs, plan sponsors have important decisions to make as we head into the second half of the year.
Glide path triggers are typically set to use a funding event to further derisk the pension plan. These funding events can be from any combination of excess portfolio returns over liabilities, higher yields, plan design changes, and/or contributions above normal cost. In the past quarter, yields have risen significantly while assets have significantly outperformed liabilities. This quarter represents a meaningful opportunity to derisk the plan and reduce surplus volatility.
While all plans and plan sponsors have their own specific goals for their plan, the decision making process to derisk or not is the same. A cash rich, highly profitable corporation with an ongoing plan might choose to not derisk their plan based on their ability to overcome funding volatility if needed. A plan sponsor who is looking to terminate their plan in the next few years might take a much more conservative approach. Another plan may choose to significantly derisk while another might choose to maintain a shorter duration bond portfolio and a heavy allocation to equities and other return seeking assets. The common denominator is the quantification of pension risk factors and making a decision based on this data to determine the most appropriate plan going forward. If the balance sheet can support left tail events, the potential scenarios cast a wider net. If not, then appropriate measures towards derisking should be more seriously considered.
Regardless of a plan sponsor’s decision to derisk and by how much, this past quarter should at the very least provide food for thought at upcoming quarterly meetings. With rates higher and significant outperformance of assets versus liabilities, Q2 of 2015 provides one of the best market driven opportunities to derisk in recent years.