The picture isn’t pretty. The average U.S. corporate pension fund is underfunded: The solvency ratio of a typical large plan plummeted below 80 percent in the second half of 2011. Why, then, are defined benefit pension funds implementing liability-driven investment (LDI) strategies in record numbers, potentially locking in these deficits at today’s very low interest rate levels? The problem is exacerbated by accounting rules that invite even well-funded plans to take on greater economic risk.
The Pension Protection Act of 2006 and Financial Accounting Standards No. 158, issued the same year, somewhat improved pension accounting and plan solvency measurement, permitting less of the smoothing of asset and liability values allowed by previous rules. Because fund liabilities are commitments to pay retiree benefits that extend into the distant future, the present value of these liabilities is very sensitive to market interest rate levels; lower rates equal higher liability values. Under the new rules corporate plan sponsors are obligated to report the difference in value between pension assets and liabilities on their balance sheets.
Plan sponsors — especially those with large pension liabilities relative to operating income — have strong incentives to reduce the accounting impact on their reported income. So despite historically low interest rates, pension plans at all levels of funding status will continue to act counter to conventional “buy low, sell high” investment wisdom. Instead, pension plans are buying high by employing LDI strategies requiring the purchase of longer-duration fixed-income assets to reduce the duration mismatch between plan assets and liabilities.
Making matters worse, the prevailing rules have taken the inherent interest rate mismatch between pension assets and liabilities and turned it into a mismatch of default risk. These rules have created a conflict between accounting and economics. The fundamental problem is the requirement that pension plans, for accounting purposes, value the actuarial cash flows projected to be owed — their liabilities — by discounting those cash flows using rates based on high-quality corporate bonds.
Companies are well aware that they must use Treasury securities to effectively defease a corporate liability. Why would a corporate pension plan value its liabilities using discount rates derived from credit-risky corporate bonds? The result undervalues a certain liability by using an uncertain, more risky discount rate. In turn, this gives plan sponsors a strong incentive to overinvest in corporate bonds. The prevailing accounting can even lure a plan sponsor into thinking that tracking error and funding deficits are low when they are not.
An LDI strategy investing heavily in long-duration corporate bonds is almost certain to underperform relative to its calculated plan liabilities, because the assets, unlike the liabilities, suffer from downgrades and potential defaults. Additionally, there exist too few high-quality long-duration triple-A and double-A corporate bond issuers — fewer than 40 at the beginning of this year — to meet the needs of even a few of the largest pension plans, let alone the entire universe of plans.
This situation has led some risk-averse plan sponsors to invest in other long-duration assets that are highly correlated with high-quality corporate bonds rather than those more highly correlated with the actual pension liabilities. The typical first misstep is investment in long-duration corporate bonds with single-A or lower credit ratings. The result: long-duration portfolios with an overreliance on one particular asset class — corporate bonds — that has much more credit risk than do the corresponding pension liabilities.
An easier to implement, less risky and economically more effective approach employs a more diversified long-duration portfolio focusing on allocations to Treasury bonds, agency debentures, corporate bonds and agency mortgage bonds. Specifically, inclusion of high-quality long-duration mortgage cash flows results in returns competitive with those of high-quality corporate bonds and a much lower tracking error to Treasury rates. Such well-diversified core portfolios have long been viewed as ideal for conservative fixed-income investors with short and intermediate duration targets. These portfolios can be customized based on the risk characteristics of the pension liabilities being matched.
History is replete with examples of bad outcomes in cases when accounting values deviated substantially from economic reality. Plan sponsors would be wise to acknowledge the issues inherent in accounting for pension liabilities and employ investment strategies using sensible measures of value, risk and return. Those who ignore the underlying economic realities in favor of accounting do so at their peril. • •
Michael Giarla is chairman and CEO of Durham, North Carolina–based asset management firm Smith Breeden Associates.
