DB Market To Experience Major Upheaval

The U.S. defined benefit pension market is going to be hit with a massive shakeup that will see three-quarters of private-sector DB assets frozen or terminated in the next five years, compared to 25% currently.

That was a key conclusion of new McKinsey & Company research that predicted at least $1 trillion in private-sector defined benefit assets will be invested in entirely different products and solutions by 2012, according to a McKinsey news release.

Asset allocations to active long-only U.S. equities will plummet by two-thirds through 2012, with long-duration fixed income, hedge funds and private equity picking up most of those losses, according to McKinsey.

Also, according to the consultant, a three-way race between asset managers, insurers, and investment banks will be in full swing by 2012 to capture share in a changing market.

In its new report, McKinsey outlines how the long track record of rock-solid earnings for investment firms serving this market is about to be turned into a roller coaster ride for many, thanks to a rare intersection of accounting, regulatory and market forces

According to the announcement, by 2012, McKinsey expects to see changes in how plan sponsors adopt entirely different approaches to portfolio construction, with a risk-driven framework replacing the one-size-fits-all approach:

  • allocations to active long-only U.S. equities will plummet by two-thirds, with long-duration fixed income, hedge funds and private equity picking up most of those losses and gaining revenues as a result.

  • risk-management solutions, using derivatives and balance sheet capabilities, will be just as important as long-established asset management products.

  • as sponsors seek to further diversify their portfolio risk, we also expect them to increase their allocations toward international asset classes.

  • sponsors will demand more sophisticated products that offer risk mitigation without sacrificing return. In particular, derivatives solutions that allow sponsors to better match the duration of pension assets and liabilities without allocating a substantial portion of the portfolio to bonds (which can depress future investment returns) will continue to be developed and refined by leading financial firms.

FASB Changes

McKinsey said that sure to have the most dramatic regulatory effect on DB plans is the rule from the Financial Accounting Standards Board (FASB) that will require companies to mark-to-market the value of their pension assets and liabilities – in other words, to recognize pension investment gains and losses immediately, rather than smoothing them out over a number of years

For example, Credit Suisse estimates that aggregate S&P 500 earnings would have plunged by 69% in 2001 if a market-based methodology had been applied to pension assets and liabilities; income would have been cut by 50% or more for 14 industry groups, ranging from aerospace to chemicals to insurance.

DB Sponsor Types

According to the McKinsey report, DB plan sponsors will break out in five basic groups:

  • These companies will be among the “first movers” in revamping their pension strategies. This group has an urgent need to take action, given their high balance sheet exposure to pension volatility. By virtue of their high pension funding levels, they also posses the financial flexibility to address the situation now. But these sponsors cannot easily alter their benefit structures – they must keep their DB plans active, due either to collective bargaining agreements with unions (as is the case, for instance, with many sponsors in the automotive or transportation sectors) or the need to use pensions as a talent retention tool (often the situation in the health care and pharmaceuticals industries).

  • In the world of DB pensions, these sponsors occupy the catbird seat: Their plans are well funded and small enough relative to the overall balance sheet to pose a low degree of financial volatility risk. At the same time, these companies possess the ability to freeze their DB plans with relative ease, should it become necessary. In essence, then, these sponsors have the freedom to do just about anything they choose when it comes to their pension investment strategies. As such, we believe they are likely to seek risk-return optimization through leading edge, innovative solutions.

  • Due to the sheer size of their pension liabilities in relation to the overall balance sheet, these plan sponsors will feel enormous pressure to overhaul their pension strategies – the accounting and contribution volatility associated with doing nothing is simply too great. This group also has the ability to make changes relatively quickly: If their DB plans are not already frozen, these companies are likely to encounter few barriers (such as the presence of a heavily unionized workforce) to doing so; we expect many of the still-active sponsors in this group to freeze in the coming months.

  • At the other end of the risk-taking spectrum are the sponsors with significantly underfunded DB plans and limited opportunities to freeze them. In an effort to get out of the underfunding hole, these sponsors will be willing to roll the dice with their pension portfolios: They have a high risk appetite, and will aggressively shop for high returns, including portable alpha, private equity, hedge funds and other alternatives products.

  • Explore new solutions in a very limited manner.

The full research report is available here.