Volatile economic conditions over recent years combined with larger funding gaps have sharpened defined benefit (DB) plan sponsors’ concerns about the financial risk posed by their plans. Towers Watson has been measuring pension risk for several years, and this year’s analysis finds minor changes in the overall risk landscape from last year.
After rising from 74% in 2012 to 88% in 2013, average funded status for Fortune 1000 pension plans fell back to 81% in 2014.1 Among companies that have been in the Fortune 1000 over the last three years, the median Pension Risk Index (PRI) ticked up slightly over the last year — from 1.2% to 1.3%. In last year’s analysis, median PRI scores had improved, falling from 1.8% to 1.2%.
Towers Watson Pension Risk Index
Fluctuations in retirement plan assets and liabilities can represent a significant financial risk for the plan sponsor. Towers Watson has 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 adverse 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 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% indicates 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 net funding liability realized over the year then divided by the company’s market capitalization. Scenarios are generated using the neutral version of 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 analytic has been modified in recent years to reflect the linked/combined movements of the pension’s financial results and the company’s stock price. The company’s market value is assumed to be affected by the equity return in each scenario, and the 5% probability outcome is reclassified accordingly. 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 ratio of the volatility of a stock or investment portfolio 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.
PRI results are now based on three alternative approaches to the presumed composition of fixed-income assets. 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). This classification represents fixed-income instruments typically used in liability-driven investing (LDI).
Estimates of the duration of plan liabilities are based on the ratio of benefit payments to the projected benefit obligation (PBO). The durations in our model range from nine and a half to 15 years and reflect the net impact of discount rates and any other linked assumption changes.
PRI values for the Fortune 1000
This analysis focuses on a consistent sample of 435 pension plan sponsors in the 2013, 2014 and 2015 Fortune 1000. Among this group, the median PRI score declined from 1.8% in 2013 to 1.2% in 2014 and then inched back up to 1.3% in 2015. Twenty-five percent of these pension sponsors had PRI scores of less than 0.5% in 2015, down slightly from 27% in 2014 (Figure 1). A score of less than 0.5% suggests that the adverse financial outcome realized in the model would impose little disruption to the company.
Figure 1. Distribution of PRI scores for 2013 – 2015 among Fortune 1000 DB plan sponsors
Click Image to Enlarge
Source: Towers Watson
In 2013, PRI scores were 10% or higher for 12% of these plans, meaning that adverse market conditions could cause a pension loss of more than 10% of market capitalization, thus posing the possibility of a large disturbance to the business. In both 2014 and 2015, PRI values were 10% or higher for only 5% of these plans.
The minor uptick in 2015 PRI scores over the past year reflects a combination of largely offsetting events. Moderate equity returns increased companies’ market capitalization by 9%, thus strengthening their overall financial position at year-end 2014. Unfortunately, lower interest rates and new mortality assumptions increased plan obligations by even more. The PRI increase would have been larger had there not also been an overall shift to more conservative asset strategies over the period.
Between 2014 and 2015, PRI values decreased for 49% of plan sponsors, increased for 47% and remained the same for 4% (Figure 2).
Figure 2. Changes in PRI scores from 2014 to 2015
Source: Towers Watson
Among the companies whose PRI scores declined, the improvement was attributable to a substantial shift in asset allocations as well as a slight decline in relative pension size. Pension size is the ratio of PBO to market capitalization. For these companies, median pension size dropped from 17.2% at the beginning of 2014 to 16.3% at the beginning of 2015. Median allocations to equity dropped from 50% at the beginning of 2014 to 44% by the beginning of 2015, so plan funding was less vulnerable to being buffeted by adverse equity markets. Overall PRI scores for this group declined from 1.8% in 2014 to 1.5% in 2015.
On the other side of the spectrum, pension risk scores increased in almost half these companies. In this group, relative plan size grew from 10.8% in 2014 to 12.6% at the beginning of 2015. Fewer of these sponsors modified their asset strategies compared with the group that reduced their pension risk: Median allocations to equity were 48% at the beginning of 2014 versus 47% one year later. Overall PRI scores for this group increased from 0.9% in 2014 to 1.3% in 2015.
What affects pension risk scores?
Relative plan size — as measured by the ratio of PBO to the sponsor’s market capitalization — is a primary driver of PRI scores. Figure 3 shows median PRI scores broken out by relative plan size.
Figure 3. Pension size (PBO/market capitalization) and PRI scores, 2015
Source: Towers Watson
Even after controlling for asset allocation and beginning-of-year risk (pension deficit/surplus over market capitalization), the association between pension size and PRI scores remains strong. For every percentage point increase in pension size, PRI scores increase by .05 percentage points. Where the financial risk of pension liabilities has become challenging, sponsors might want to think about reducing retiree or other inactive obligations, such as by purchasing annuities from a third-party insurer.
Asset allocation also plays a role in PRI scores, but it is less influential than plan size. To reduce investment risk, more plan sponsors allocated a larger share of pension assets to fixed-income investments over the past year.2
Figure 4 compares median PRI scores with the percentage of assets held in fixed-income instruments. Plan sponsors that hold the majority of assets in bonds generally have lower PRI scores. For every percentage point increase in debt allocations, PRI scores decrease by .03 percentage points.
Figure 4. Asset allocations to debt and PRI scores, 2015
Source: Towers Watson
LDI strategies typically use fixed-income assets as a hedge against interest rate movements; lower interest rates increase plan obligations. For example, on a financial accounting measurement basis, in years when long-term, high-quality corporate bond interest rates decline and plan obligations rise, corporate bonds should realize positive returns and vice versa.
Our PRI model assumes that sponsors that allocate the majority of their assets to fixed income have adopted an LDI strategy. To get a better sense of how higher debt holdings can reduce risk, Figure 5 shows 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 5. PRI outcomes under different asset allocations and bond durations, 2015
Source: Towers Watson
Bond returns are less volatile than stock returns and thus can mitigate losses in adverse financial markets. Moreover, pension risk scores drop even further among companies that allocate assets to long-duration bonds to hedge interest rate movements and their impact on liabilities. While large equity positions can reduce long-term pension cost, the trade-off is higher market risk and funding volatility.
According to our analysis, the risk pension plans impose on companies’ finances increased minimally from 2014 to 2015. The minor uptick in PRI scores over the past year reflects a combination of largely offsetting events. Moderate equity returns increased companies’ market capitalization by 9%, but lower interest rates and new mortality assumptions increased plan obligations by even more. While these market and other conditions would normally push pension risk scores higher, asset strategies over the year mitigated some of the potential increase overall. There is a direct correlation between relative pension size and higher risk scores, as well as between greater debt holdings and lower risk scores, although the correlation is weaker for the latter.
So far in 2015, the financial environment has been a mixed bag for pension funding. Over the first three quarters, interest rates rose by almost 30 basis points, thus driving down pension liabilities. At the same time, returns in both domestic and international stock markets dropped by roughly 7%, and bond markets also underperformed: Returns on long duration bonds (corporate and Treasury) have been between 1% and -4%. If these market trends continue, some plan sponsors could face funding shortfalls (albeit not nearly as large as in 2014) and lower company values by year-end 2015.
Companies whose pensions pose significant financial risks to their business might want to consider de-risking their plans by shifting from equity to debt and other less market-sensitive investments, and better matching the duration of plan assets to plan liabilities. These sponsors could also lower their pension risk by reducing retiree and other inactive obligations, such as by purchasing annuities. As noted above, where there is risk, there is also opportunity and plan sponsors should consider where they stand on the spectrum.
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