The fourth quarter provided a tremendous amount of pain for Pension America. The feared double whammy occurred in which interest rates fell, increasing the present value of a plan’s liabilities, while assets simultaneously fell, too. The combination impacted plan funded status and future contribution expense.
What could have been done to mitigate this risk? For plans focused on the return on asset assumption (ROA) as the primary objective, I would suggest that not much would have or could have been done. ROA chasers have a set it and forget it mentality. This “strategy” has unfortunately been the primary pension game for about 40 years coinciding with the explosion in the use of asset consulting firms.
For those few plans that are focused on the plan’s assets versus that plan’s specific liabilities, the end of the third quarter would have provided an outstanding opportunity to reduce risk within the portfolio in a responsive way. However, in order to implement this action, one would have had to be monitoring their plan liabilities more frequently than the once per year view that is customary.
What was the opportunity? At the end of September 2018, a “traditional” asset allocation would have generated a return of 5.8% year-to-date. Furthermore, the backup in U.S. interest rates reduced the present value of plan liabilities (using US Treasury STRIPS) by -5.3%. The combination of these two actions would have worked to improve funding status in a dramatic way. It would have been the perfect time to move assets from your “growth” portfolio to an insurance bucket designed to meet near-term benefit payments. Few did!
As a result, the fourth quarter’s equity swoon created significant headwinds for that sample plan asset allocation, and by the end of the year, the plan would have generated a -3% return. A collapse of 8.8% in a single quarter. Worse, U.S. interest rates began to fall. The U.S. Treasury 10-year saw it’s yield fall from a high of 3.24% to the year-end low of 2.68%. For all of 2018, the U.S. 10-year had rates rise only 22 basis points. So much for significantly higher rates coming. The Treasury STRIP yield curve produced a -1.26% return for the full year, but that was improved by 4% in one quarter.
If plan sponsors and their consultants had implemented more of a liability focus, they could have protected the funded status and future contribution expense by taking risk off the table at the point when assets were outperforming liabilities by 11.1%. Instead, the set it and forget it mentality resulted in plan assets underperforming a true market-to-market liability growth rate by -1.7%. We cannot afford to sit by any longer with the wrong pension objective. Plans must be managed against the promise that they’ve made to their participants.