US Pension Fund Fitness Tracker of UBS Global Asset Management, a quarterly estimate of the overall health of a typical US defined benefit pension plan, shows pension funding ratios increased by 6 percentage points in the first quarter of 2009.
According to the US Pension Fund Fitness Tracker, the typical US pension fund started 2009 with a funding ratio of approximately 78% and ended the quarter higher at approximately 84%.
This increase is attributable to higher discount rates which led to a lower present value of pension liabilities. Corporate credit spreads widened while interest rates rose, which led to a higher corporate bond yield curve and pension discount rate. The decrease in liabilities was partially offset by volatile equity markets that finished the quarter lower, which decreased the value of the asset pool from which plan participants’ benefits are paid.
For the quarter, pension discount rates (which are based on the yield of high quality investment grade corporate bonds) for a typical pension plan increased over 100 basis points during the quarter, which decreased the present value of pension liabilities. This decrease was offset slightly by interest cost. For the quarter, the overall liability return was -14%.
From a long-term policy perspective, sponsors should use caution when considering adding credit to the liability hedging component of an LDI solution. During periods of economic stress, bond defaults rise which will cause losses on the liability hedge, while pension liabilities are not subject to default risk. As a general rule, the greater the exposure to risky return generating assets, the less credit risk should be in the liability hedging assets.
Equity markets remained volatile throughout the first quarter and finished the quarter down 11% as investors balanced weak economic and corporate earnings reports against unprecedented fiscal and monetary policy response,” says Aaron Meder, head of Asset Liability Investment Solutions, UBS Global Asset Management, Americas. Overall, the decline in assets was more than offset by a large decrease in liabilities which led to an increase in the typical plan’s funding ratio for the quarter.”
“As plan sponsors consider implementing an interest rate hedging approach, it is imperative that they have a strategy in place to implement the hedge as a function of interest rate, funding ratio and calendar triggers, continues Meder. “For example, as interest rates begin to increase, plan sponsors should add duration to their portfolios via long duration bonds and/or interest rate derivatives to lock in their funding ratio gains (as the present value of liabilities fall faster than the value of assets) while reducing funding ratio risk.”
L.D.