A coronavirus game plan for defined benefit pension plans
April 2, 2020
The novel coronavirus has introduced unprecedented volatility to financial markets and is taking its toll on pension plans.
We’ve seen sharp corrections in most equity markets. At its lowest point in the correction to date, the S&P 500 lost 34 per cent of its value, from its peak in February. The TSX, which has also been hit by a slump in oil prices, has lost 37 per cent of its value, from its February high.
It is unclear if the market has hit its bottom or has more room to fall. The market was somewhat overvalued, prior to the correction. Historically, the S&P 500 has traded at an average price-to-earnings ratio of around 15, or $15 for $1 of current year earnings. At its February peak, the S&P 500 was trading at a price-to-earnings ratio of 25, which is somewhat expensive. This result is not surprising, given the low interest rate environment and the prolonged bull market over the last 10 years.
Following the recent correction, the price-to-earnings of the S&P 500 is estimated at around 19. This is not cheap, but well within normal trading ranges. The market must assess the strength of the economic pause and its impact on economic growth rates, unemployment levels and spending levels. We can expect company earnings levels to be impaired over the near term, which may put further downward pressure on stocks.
Further, the levels of volatility experienced over the last month in the financial markets are unprecedented. Over the last year, the S&P 500 has been relatively stable and the Chicago Board Options Exchange’s volatility index, or the VIX, has fluctuated between 10 and 20. Since the beginning of March, VIX levels have steadily risen. In the last two weeks, the VIX has fluctuated between 65 and 85, which exceeds volatility levels at the apex of the credit crisis, where the VIX ranged from 40 to 70. This environment has resulted in equity swings of more than ten per cent in a day.
There are two different elements of the bond market that have reacted quite differently to the pandemic. Government bonds prices have risen sharply as investors flock to low-risk assets. This has driven down the yield for government bonds across the yield curve. For example, the 10-year Canada yield has fallen by more than 0.5 per cent over last month. At the same time corporate bond yields have ballooned, as selling pressure has increased for all risk assets. For example, single-A rated corporate bonds have seen their spreads widen by more than 100 basis points, from their lows in February. Lower quality corporate bonds have seen their spreads widen significantly more. The net impact for the TMX universe bond index at its lowest point in the correction, is a fall of 14 per cent from its February peak.
The market correction has also negatively impacted alternative asset classes, such as real estate, high-yield bonds and mortgages, as the ability of income-generating properties to generate income has been impaired by the potential for increasing defaults, bankruptcies and increases in vacancy rates. Generally, a major benefit of alternative asset classes is the illiquidity premium that they pay investors. However, the price of this illiquidity premium is paid in times of market stress. When risk assets come under selling pressures, often less liquid alternatives also sell off. This not only puts downward pressures on prices, but may also limit liquidity.
In this difficult environment a prudent pension committee should remember the following key principles:
Don’t panic – Markets are cyclical and will, at some point, stabilize. Unexpected market shocks often result in panic selling, which may cause assets to overcorrect. Investors who maintain a steady hand and avoid joining the stampede, will tend to perform better in the long run. Pensions have a long-term time horizon, which supports a more long-term focus. At the same time, most pension funds utilize professional portfolio managers who will constantly evaluate developing opportunities and threats in the market. In many cases, they will be actively repositioning your portfolios to optimize the strategies in times of stress.
Ensure prudent oversight – It’s important to maintain prudent oversight of the portfolio in times of market stress. Certain industries, such as airlines, travel, cruises, hotels and retail will likely experience a prolonged downturn. In some cases, the impairment will be permanent. For example, as businesses are learning to replace face-to-face meetings with on-line selling and support, travel patterns may be permanently altered. At the same time, industries, such as on-line retail, on-line meeting platforms and cloud providers may experience a permanent increase in their customer bases.
You should assess how well your manager is adapting to these emerging trends. By virtue of their investment approach or style bias, they may have an easier or harder time adjusting to the new market environment. Despite the challenges presented by the pandemic to in-person meeting, it is important that a pension committee continue meet virtually and monitor the performance of their portfolio.
Rebalance – Your asset mix was set to meet your long-term return objectives, while maintaining prudent risk levels. A market shock will often move the portfolio outside of its asset mix ranges. Rebalancing will help to move the portfolio back within your long-term risk/return targets. It will also help you to sell the better performing assets and re-allocate the proceeds back to the underperforming asset classes, a long-term recipe for success in the markets, which tends to be somewhat cyclical.
Be Aware of Your Funding Position – Depending on your portfolio strategy, the market correction may have a large impact on your funding position. For plans employing a liability-driven investment matched strategy, using government bonds, the funding position will largely be isolated from the market turbulence. This is the primary benefit of an LDI strategy, which will underperform risk-based strategies in normal markets. To the extent that your LDI strategy employs credit or other spread strategies, the correction may have a negative impact on funding levels.
For more traditional strategies, the market correction may have significantly impaired your funding position. A typical balanced fund would have lost about 25 per cent of its value, from the recent peak to the market bottom. This could take a fully-funded plan in Ontario below the 85 per cent solvency threshold.
While this change will not immediately impact your plan or required funding levels, it could be a factor in changing the timing of your valuation. For example, a plan due for its tri-annual valuation on January 1, 2021, that is negatively impacted by the correction, may wish to consider voluntarily filing a year early, to avoid the negative funding impact of the correction.