Worries about the European debt crisis, declining Treasury bond yields, and expectations that the Federal Reserve will continue to hold interest rates low in coming months have combined to leave investors – as a group – scratching their heads about the direction of their fixed income portfolios.
But only up to a point. More so than at any time in recent years, corporate and public pension plans are focusing on their long-term funding and liability requirements as they determine their fixed-income strategies, according to pension researchers and consultants. Those long-term needs appear to be sending corporate and public pension managers in precisely the opposite direction from one another.
One in four U.S. corporate pension funds, according to Greenwich Associates, expect to “significantly increase” their allocation to U.S. fixed income over the next three years – by far, the most aggressive posture they are assuming for any major asset class. On the public funds aide, meanwhile, only 11 percent say they plan to significantly raise their domestic bond allocation, with private equity, real estate, and hedge funds all commanding greater attention over the next three years.
“Corporate pension plans are driven by the need to de-risk,” says Goran Hagegard, consultant at Greenwich Associates. “They see their pensions as liabilities, not assets, that need to be managed like liabilities. That means selling out of U.S. equities, into fixed income, neutral on international equity, and into hedge funds – because they’re seen as being able to deliver on the promise of a hedged return.”
Public funds labor under the burden of less-than-reassuring ratios of assets to liabilities. And compared with their private-sector counterparts, public employers have more difficulty renegotiating pension deals with their workers or converting traditional defined benefit plans to a more flexible structure. Add to that the fact that “there aren’t many tax dollars to contribute to improve funding,” and the result is “a willingness to add risk to increase returns,” says Hagegard. So while public pension fund managers are not adding to their domestic fixed income portfolios, “they are entering into international fixed income – where yields, as they are, pose attractive opportunities – and into hedge funds – but to add return, not to hedge.”
By contrast, a just-released study by Mercer of pension investment patterns of S&P 1,500 companies revealed average fixed income allocation jumping from 33 percent to 41 percent in 2008, dropping to 38 percent in 2009, and then jumping back to 39 percent last year – that last in spite of a broad equity market rally. Average equity allocation during the same four-year period slipped from 55 percent to 50 percent.
Jonathan Barry, a partner with consultant Mercer’s Retirement, Risk and Finance group, traces the divergence between public and corporate funds’ management of their fixed income portfolios to the Pension Protection Act of 2006. That law prescribed a discount rate for private sector defined benefit plans based on very high-quality – A-rated and higher – corporate bonds. That stringent standard prompted many employers to freeze their plans, close them to new employees, “and in general begin asking, ‘what is the end game for our plan?’” says Barry.
Some have adopted “dynamic de-risking strategies:” systematically removing risk as the plan’s funded status improves. “If, say, funding the assets-to-liabilities ratio improves from 79 percent to 81 percent funded, they may reduce their stock-to-bond ratio from 65-to-35 to 55-to-45,” says Barry. “So over the next few years, when equities are doing well, they’ll capitalize on the improvement to shift to a less risky profile.”
But even for corporate plans that do not adopt dynamic de-risking, “fixed income will have a much bigger role going forward,” he adds. “This, despite the fact that we have very, very low interest rates and equity markets are doing reasonably well.” That in turn will affect their objectives in picking investments within the fixed income universe and selecting managers.
“The key isn’t trying to get extra return,” says Barry. “Your liabilities will always be calculated according to high-quality corporate bond rates. So you want fixed income assets that aren’t going to default on you. Fixed income managers need to understand your plan’s liabilities and work to that preference for high-quality bonds.”
