Potentially volatile financial markets coupled with growing pension liabilities due to falling interest rates have prompted ongoing concern about the risk defined benefit (DB) plans can pose to the sponsor’s core business. Large shortfalls in funded status negatively affect corporate earnings and risk profiles, making risk management strategies increasingly popular among pension managers and sponsors.

Among the Willis Towers Watson (WTW) Pension 100, average funded status climbed to 90.4% in 2013, boosted by rising interest rates and a prosperous stock market. By 2014, however, mostly due to lower interest rates and the widespread adoption of new mortality tables, funding was back down to 82.4% — where it has stayed. Investment returns in 2016 were just high enough to offset rising obligations, leaving funded status still at 82% by year-end 2016.

Willis Towers Watson has been measuring pension risk for several years,1 and this year’s analysis finds minimal change in the overall pension risk landscape. Among companies in the 2017 WTW Pension 100,2 the median Pension Risk Index (PRI) was 1.9%, the same as it was last year. Risk scores have inched up over the last four years, increasing from 1.5% in 2014 to 1.9% in 2017.

Willis Towers Watson PRI

Fluctuations in retirement plan assets and liabilities can pose a significant risk to the plan sponsor. In order to track pension risks, Willis Towers Watson developed a measure of one-year value at risk (VaR) in a pension plan relative to the sponsor’s market value under a simulation of adverse financial conditions. The VaR is the increase in the funding deficit (as measured for financial accounting purposes) under unfavorable market conditions, given the plan’s asset allocation and funded status at the beginning of the year. The PRI quantifies the pension risk in additional pension underfunding to a company’s core finances over the following year and allows for a risk comparison among plan sponsors.

The adverse market condition is modeled as a 5% probability outcome. For example, a PRI value of 4% suggests that an increase in the pension plan’s funding deficit over the coming year will exceed 4% of the company’s market value, 5% of the time.

To perform the analysis, pension plan assets and accounting liabilities are stochastically simulated for 25,000 scenarios, with the change in funding liability realized over the year then divided by the company’s market capitalization. Scenarios are generated using the neutral version of Willis Towers Watson’s capital market assumption model and reflect a composite of asset class returns and interest rate changes projected by the model.

The PRI reflects the linked/combined movements of the pension financial results and the company stock price. PRI results are based on three alternative approaches to the presumed composition of fixed-income assets.3 It is assumed that the company’s market value is affected by the equity return in each scenario. The analysis calculates standard corporate beta for each company because all companies do not respond to market fluctuations in the same way.

Beta measures the risk potential of a stock or investment portfolio expressed as a ratio of its volatility to overall market volatility, with 1.0 representing the market. This equity market benchmark is often estimated using a representative index, such as the S&P 500. For example, a portfolio whose beta exceeds 1.0 is expected to experience greater volatility than the overall equity market, while a portfolio whose beta is less than 1.0 is expected to have less volatility than the market.

Estimates of the duration of plan liabilities are based on the ratio of annual benefit payments to the projected benefit obligation (PBO). As the ratio increases, our estimate of the duration of liabilities declines. The durations in our model range from 9.5 to 15 years and reflect the net impact of discount rates and any other linked assumption changes.

PRI values for the WTW Pension 100

This analysis focuses on employers in the current WTW Pension 100 and looks at their risk scores from 2014 to 2017. Among this group, median PRI scores have been moving upward: from 1.5% in 2014 to 1.7% in 2015 and to 1.9% in both 2016 and 2017 (Figure 1).

Figure 1. Median PRI scores for the 2017 WTW Pension 100, 2014 – 2017

Figure 1. Median PRI scores for the 2017 WTW Pension 100, 2014 – 2017

Source: Willis Towers Watson

Over the last three years, the percentage of companies with PRI scores below 0.5% declined steadily from 23% in 2014 to 14% in 2017 (Figure 2). A score of less than 0.5% means that the adverse financial outcome in the model would impose little disruption to the company’s core finances. Over the same period, the concentration of sponsors with scores in the 0.5% – 0.99% range increased from 18% in 2014 to 22% in 2017.

Meanwhile, the number of companies with PRI values exceeding 10% has remained relatively stable. Seven companies had scores higher than 10% in 2017, suggesting that the adverse market condition modeled could pose the possibility of a large disturbance to the core business.

Figure 2. Distribution of PRI scores for 2014 – 2017 for the 2017 WTW Pension 100

Figure 2. Distribution of PRI scores for 2014 – 2017 for the 2017 WTW Pension 100Click to enlarge

Source: Willis Towers Watson

The overall 2017 pension risk profile remained unchanged from 2016. Discount rates declined 29 basis points during 2016, which increased pension obligations. Double-digit equity returns boosted companies’ market capitalization and pension assets, offsetting the higher liabilities.

The annual changes in capital market assumptions used in our modeling had no substantial effect on scores for 2017. Annual differences in individual scores over the last year were attributed to changes in the sponsor’s characteristics, such as pension size and asset allocation, as well as the company’s volatility relative to the market (measured as the company’s beta).

Between 2016 and 2017, PRI scores declined for 54 companies (Figure 3), with the median score falling from 2.7% to 2.2%. Among these plan sponsors, the median relative pension size (PBO over market capitalization) fell from 23.2% at the beginning of 2016 to 19.7% at the beginning of 2017. This decrease in relative size was attributed to a spike in company value — median market capitalization increased by 23% over 2016.

Figure 3. Changes in PRI from 2016 to 2017

Figure 3. Changes in PRI from 2016 to 2017Click to enlarge

Source: Willis Towers Watson

Conversely, among companies whose risk scores increased over the year, relative pension size grew slightly, from 22% at the beginning of 2016 to 23% by the beginning of 2017. Median market capitalization increased by only 2% for this group, which wasn’t enough to keep up with rising pension obligations. For these plan sponsors, median risk scores rose from 1.7% to 2.2% by 2017.

Risk scores for the five companies whose values did not change were 0%, meaning that their plans are so well funded that the 5% adverse financial scenario would have no impact on their pension plan or core business.

What affects PRI scores?

Relative pension size is a primary driver of PRI scores. Figure 4 shows median PRI scores broken out by relative pension size.

Figure 4. PRI by pension size (PBO/market capitalization), beginning of 2017

Figure 4. PRI by pension size (PBO/market capitalization), beginning of 2017

Source: Willis Towers Watson

Even after controlling for asset allocations, the association between pension size and PRI scores remains strong. For every percentage point increase in pension size, PRI scores increase by 0.14 percentage points.

Over the last decade, plan sponsors have continued to allocate a larger share of assets to fixed-income investments, often as part of a liability-driven investment (LDI) strategy.4 LDI strategies use fixed-income assets as a hedge against higher liabilities resulting from interest rate declines.

Asset allocation also plays a role in PRI scores. Figure 5 compares median PRI scores with the percentage of assets held in fixed-income instruments: As fixed-income holdings increase, the value at risk for the oncoming year declines. Overall, after controlling for other factors, a one-percentage-point increase in allocations to debt reduced PRI scores by 0.08 percentage points.

Figure 5. Asset allocations to debt and PRI scores, 2017

Figure 5. Asset allocations to debt and PRI scores, 2017

Source: Willis Towers Watson

Our PRI model assumes that sponsors that allocate the majority of their assets to fixed-income investments have adopted an LDI strategy. To get a better sense of how higher debt holdings can reduce risk, the following scenario highlights a company under three asset allocation scenarios (with plan size, funded status, market capitalization and other parameters being equal), as well as under three bond durations (Figure 6).

Figure 6. PRI outcomes under different asset allocations and bond durations, 2017

Figure 6. PRI outcomes under different asset allocations and bond durations, 2017

Source: Willis Towers Watson

As the asset portfolio moves toward bonds, overall pension risk declines. While large equity positions can potentially reduce long-term pension cost (and have done so historically), the trade-off is volatility.

Are companies’ risk profiles mirrored in their PRI scores?

To determine whether pension risk is reflected in a company’s overall risk profile, we divided the sample into two categories by bond rating: investment grade and non-investment grade.5 The overall median PRI score is 1.6% for the investment-grade group (88 companies) versus 13.7% — over eight times higher — for the non-investment-grade group (12 companies).

Figure 7 depicts the PRI distribution among investment-grade and non-investment-grade companies. PRI scores were less than 2% in 58% of investment-grade companies compared with none of the companies rated BB+ or lower. Further, more than half of those companies rated as non-investment grade had PRI scores of 10% or higher.

Figure 7. Investment-grade versus non-investment grade PRI scores, 2017

Figure 7. Investment-grade versus non-investment grade PRI scores, 2017

Source: Willis Towers Watson

The pension risk profile as measured by the PRI correlates to the sponsor’s overall risk profile as measured by the S&P credit rating.

The total dollar value at risk6 of non-investment-grade sponsors represents only 9.6% of the sample’s additional risk (Figure 8). The seemingly smaller increase in potential underfunding for the non-investment-grade group reflects the significantly higher value of the investment-grade group.

Figure 8. Total dollars at risk by credit rating ($ millions)

Figure 8. Total dollars at risk by credit rating ($ millions)

Source: Willis Towers Watson

Liability management and PRI

Over the last several years, plan sponsors have increasingly focused on reducing pension obligations to help alleviate pension risk by: (1) offering terminated vested participants the option of receiving their pension benefit in a lump sum versus having it paid out in the form of an annuity, and/or (2) transferring a portion of the pension obligations to third-party insurance companies through annuity purchases.

To evaluate the impact of these activities on PRI scores, we paired these de-risking strategies among the WTW Pension 100 between 2014 and 2017 with our PRI database. Figure 9 compares median PRI scores between companies that implemented de-risking strategies (lump sum payouts or annuity purchases) during the four-year period ending December 2016 with those that did not. During this period, 46 companies implemented de-risking strategies, and 29 of them did so more than once.

Figure 9. Median PRI score by de-risking activity, 2014 – 2017

Figure 9. Median PRI score by de-risking activity, 2014 – 2017

Source: Willis Towers Watson

Throughout the analysis period, companies that implemented liability reduction strategies had lower risk scores relative to those that didn’t. PRI scores increased by 35 basis points for sponsors that employed liability reduction strategies versus 53 basis points for sponsors that did not use such strategies.

Conclusion

According to our analysis, the risk posed by pension plans to companies’ core finances remained roughly equal from 2016 to 2017. The lack of movement in the median PRI score over 2016 reflects a combination of factors. Higher liabilities (due to lower interest rates) were offset by relatively strong equity returns, which kept plan funding stable during the last two years and drove market capitalization higher.

So far in 2017, market movements have been similar to those witnessed toward the very end of 2016. Over the last few months, equity returns have been at or just above expectations, while interest rates for high-quality corporate bonds (the basis used for measuring pension obligations for accounting purposes) declined by 25 basis points from January to early June, pushing liabilities higher. If these conditions persist, sponsors’ funding positions might not change much from year-end 2016 to year-end 2017.

Companies whose pensions pose significant risks to their core business might want to consider de-risking their plans. Risk-reduction strategies — such as asset-liability duration matching and shifting from equity to debt (and other less market-sensitive investments) — can help sponsors lower their risk profile. Moreover, measures oriented to reduce obligations through lump sum buyout offers and/or annuity-based strategies can also lower pension risk.


Endnotes

1. See “Pension risk increases slightly for WTW Pension 100 in 2016, Willis Towers Watson Insider, June 2016.

2. The 2017 WTW Pension 100 consists of sponsors of the 100 largest U.S. pension programs among U.S. publicly traded organizations, ranked by PBO at the beginning of 2016.

3. If less than 40% of plan assets are invested in fixed income, the model assumes the plan’s fixed-income assets are invested in Barclays Capital Aggregate Bond Index (duration generally five to five-and-a-half years). If 40% to 50% of assets are invested in fixed income, the model assumes the fixed-income portfolio is invested in a blend of 50% Barclays Aggregate Bond Index and 50% Barclays Capital Long Government/Credit Index (duration roughly 10 years). For plans with more than 50% invested in fixed income, all fixed-income assets are assumed to be invested in Barclays Capital Long Government/Credit Index (duration generally 14 to 15 years).

5. The categories reflect the S&P rating, which classifies companies rated BBB– or higher as investment grade and those rated BB+ or lower as junk bonds.

6. Dollars at risk equal PRI score multiplied by the company’s market value.