Thanks to the Pension Protection Act (PPA), retirees may soon have to worry about returns, not underfunding. The new law, coupled with FAS 87's restrictions on smoothing pension earnings over time, encourages fund managers to be more risk averse and to match the duration of a portfolio's assets with its liabilities. And this so-called liability-driven strategy may sharply curtail gains in favorable markets.
The PPA requires that fund managers calculate pension liabilities based on current bond rates rather than the expected rate of return from a portfolio. Thus, liabilities will be more sensitive to interest rates, and high expected gains from stocks can no longer help diminish them, since they are no longer part of the calculation. "In the past, there was more of an incentive to invest in equities because they could lower your current cash contributions," says Mark Ruloff, director of asset allocation at Watson Wyatt Investment Consulting. "Actual returns will reduce contributions, of course, but the gain is no longer guaranteed."
Even before the ink had dried on the law, which passed in August, companies had started eyeing safer returns. In a survey published in October, Towers Perrin found that about 25 percent of companies would consider weighting portfolios more toward bonds or making more use of derivatives to compensate for the new prominence given to interest rates. As of 2005, only 3 to 6 percent of U.S. corporate pension plans took such steps as matching asset and liability durations through derivatives to buffer their portfolios from rate fluctuations, according to Greenwich Associates.
International Paper has already started down that path. According to Bob Hunkeler, vice president of investments, the company decided to better match the duration of its pension assets and liabilities in 2002 after getting burned by the bear market. With the support of then-CFO and now-CEO John Faraci, IP started by hedging its fixed-income portfolio against interest-rate movements. In 2006, it began hedging its entire portfolio. So far, the company hasn't changed its underlying asset mix, but has instead used derivatives, such as interest-rate swap overlays. It now has 35 percent of the liability of its portfolio hedged, and the $7.4 billion plan actually made money on the swaps it put in place this year, Hunkeler says.
It remains to be seen how many companies will make similar moves. Those that do are likely to go slowly, says Judy Schub, managing director for the Committee on the Investment of Employee Benefit Assets. "Very few people will go toward a totally liability-driven portfolio, since there's no upside potential," she says. "If you were to take it to its logical conclusion, you'd end up with more-expensive pension plans."