By Gertrude Chavez-Dreyfuss and Richard Leong
NEW YORK (Reuters) - Low interest rates and a U.S. stock market that is still down 2 percent for the year have taken their toll on corporate America's pension plans.
Pension liabilities grew 1 percent in the third quarter, as returns fell 2.5 percent, according to global consulting firm Milliman. The increase in the pension shortfall has been largely driven by investment losses in August and September, low discount rates used to value pension liabilities, and recent studies showing that people are expected to live longer over the next 20 years.
While the government has granted relief into 2021 for companies to improve their pension funding, corporate executives with severely underfunded pensions have some urgency to take action, or pay stiffer premiums to the federal Pension Benefit Guaranty Corporation to insure their programs.
As a result, companies with some of the larger unfunded liabilities have started to load up on riskier assets such as stocks and junk bonds to make up for lost ground in hopes they do not have to contribute more cash, pension managers and consultants say.
Private pensions added nearly $50 billion in so-called "other" assets, which pension consultants say could include hedge funds and private equity. The investment in other assets is nearly double the $26 billion invested in the second half of 2014 and far more than the $14.2 billion invested in all of 2010, according to Federal Reserve data.
Market losses and low interest rates have also slowed the $2.4 trillion sector's move into the safety of long-term bonds, Fed data showed, as many had planned to do when they reached a high funding status.
Insurer American International Group Inc, for example, aims to grow its holdings of alternative investments that include hedge funds and real estimate by nearly 80 percent this year, while trimming its bond exposure, according to regulatory filings.
"Things are moving in the wrong direction," said Andrew Wozniak, head of BNY Mellon Fiduciary Solutions in New York.
"They are trying to find the right balance between contributing to improve the funding status and taking more risk within the pension plan to have a higher return to close that funding gap."
Thirty seven of the top 100 U.S. corporate pensions by assets tracked by Milliman had funding ratios below 80 percent at the end of 2014, more than double that level in 2013.
The overall funding ratio for these U.S. companies fell to 81.7 percent in September this year, down from 85.5 percent at the end of June, Milliman data showed.
The funding ratio measures a pension's solvency, and 80 percent for many plans closed to new entrants has generally been considered a threshold in which they should be thinking about moving into fixed income to preserve gains. Falling below that level could delay a pension's move to the stability of fixed income assets that would help cushion portfolios from market volatility.
TURNING TO RISKY ASSETS
Among the underfunded corporate pension plans in Milliman's top 100 at the end of 2014 were Delta Air Lines Inc with a 42.8 percent funding level and American Airlines Group Inc at 62.4 percent.
AIG, which had a funded ratio of 70 percent at the end of last year, has targeted an increase in other investments to 31 percent this year from 17 percent in 2014, according to the company's 2014 annual report, while lowering its bond allocation to 27 percent from 28 percent in 2014.
American Airlines and AIG declined to comment.
In addition to heavily loading up on riskier investments, Delta is also pumping $1 billion a year into its pension through 2020.
Delta, whose funding level is the lowest among the Top 100 companies in the Milliman index, should reach an 80 percent funded ratio in the next five years, according to financial documents provided by the company.
Only 12 percent of the airline's pension is invested in fixed income with 21 percent in equities and the rest in other investments.
The airline has been severely underfunded over the last three years, with funding ratios of 46.9 percent in 2013 and 38.1 percent in 2012.
Frank van Etten, head of client solutions at UBS Global Asset Management, which oversees $695 billion in assets, said some pensions needed to take on more risk due to higher return targets.
"We do expect more shifts in allocations given the decreased levels of funding ratios," Chicago-based Van Etten added.
Adding to their burden, the Society of Actuaries last year estimated retirees are living longer than just a decade ago, a factor the Internal Revenue Service is expected to adopt in 2017 when calculating pensions' future payouts.
The shift into bonds by corporate pensions was part of a derisking process that began in the last three years as their obligations declined and funding levels improved.
The objective is to move 50 percent to 80 percent of pension assets into long-term bonds, usually corporate investment-grade debt.
But that goal may have to wait now, pension consultants say.
"What we have seen is a delay in moving into long-duration bonds while they're waiting for the long end of the (yield) curve to go higher and market conditions to improve," said Philadelphia-based Charles Tan, head of North American fixed income at Aberdeen Investments, managing more than $480 billion in assets.
Fed data showed that private pensions' bond purchases tumbled to $7.4 billion in the second quarter, from $56.5 billion in the first quarter.
One reason for the drastic decline in bond purchases, analysts say, is the expectation of an interest rate increase by the Fed, which diminishes the value of the bonds.
From 2012 to 2014, private pensions have amassed more than $250 billion in fixed-income debt.
At the end of last year, fixed-income allocation grew to 42.7 percent from 39.5 percent at the end of 2013, Milliman data show.
Despite expectations for a Fed rate hike, longer-term bond yields have declined, a factor in computing discount rates used to estimate pension liabilities. Lower discount rates, which are based on the yield of high-quality corporate bonds, increase a pension plan's projected liabilities.
Pension discount rates fell to 4.19 percent in September, from 4.23 percent in August and down more than 2 percentage points since the global financial crisis in 2008.
"There is a greater deficit now on the balance sheet. They are feeling more of that pain from a cash and financial statement perspective," BNY Mellon's Wozniak said.
(Reporting by Gertrude Chavez-Dreyfuss and Richard Leong; Editing by Lisa Shumaker)