Many DB plans are sitting with a fairly modest exposure to fixed income, as sponsors and consultants anticipate higher interest rates. Unfortunately, the current economic environment isn’t cooperating with that thought process and asset allocation decision. Despite the Fed’s action in December to raise the discount rate by 25 bps, it doesn’t appear that there will be any follow through in the coming months.
Unfortunately, S&P 500 earnings are the weakest they have been since the great financial crisis, marking three consecutive quarters of negative earnings. Couple this news with the fact that consumer sentiment has fallen and that home ownership is at a 48 year low, where is the catalyst for economic expansion and inflation, which would provide the thrust necessary to see rates lift off?
Furthermore, a significant percentage of global bonds are currently trading with negative real yields, making the US rate environment very attractive on a relative basis. As such, both the fundamental and technical factors support rates remaining at or below these levels. Neither scenario is good for pension liabilities, which change in value based on current interest rates (no they don’t grow at the ROA!).
DB plans should initiate a de-risking approach where current fixed income exposure is used to meet near-term retired lives, thus mitigating interest rate sensitivity, while enhancing liquidity and extending the investing horizon for the balance of the fund’s assets. Managing a DB plan is about providing the promised benefit at the lowest cost. Continuing to use the ROA as the primary objective injects too much risk / volatility into the asset allocation process.