Defined Benefit

For Corporate Pension Plans, We Have Good News and Bad News

For Corporate Pension Plans, We Have Good News and Bad News
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1 min 47 sec

While corporate pension plans have benefited from the rebound in equities since the bumpy fourth quarter of last year, they are facing a challenge on another front: the long duration rates used to discount pension liabilities have been moving in the other direction—a lot.

The discount rate used by the short-duration FTSE Pension Liability Index has plunged 127 basis points from Dec. 31 through Aug. 31, from 4.05% to 2.78%. Substituting in an estimated duration for the average corporate pension plan (approximately 13 years), those plan sponsors would have seen an increase in their pension liabilities of almost 17%.

This example may provide some clarity about the implications. In August, the S&P 500 fell about 1.6% while the Bloomberg Barclays US Long Government/Credit Index gained about 8% for the month. A hypothetical 60% U.S. stocks/40% U.S. fixed income portfolio would have been up approximately 2.2% for the month, but a plan’s pension liabilities would have increased about 6% (per an approximated 42 bps decrease in the FTSE Pension Liability Index over the month). A plan that was 85% funded at the beginning of the month would have fallen to about 82% funded, not counting cash flows. Duration is extending as rates fall again, so as funded status gets worse, not only does the cash flow negativity of most DB plans become a bigger problem, but the sensitivity to further rate moves gets worse. Assuming the market is relatively tame (unlikely), that may mean bigger contributions for next year. Hedging interest rate risk has always been a good idea for these plans, and environments like this further reinforce that point.

There is some good news. The pricing for pension risk transfers has likely increased dramatically, dampening that activity in the near term after a significant increase in the level of those transactions through the first quarter. The door may also be open for some plans to think about borrowing to increase funding, if their balance sheets can handle the leverage and if the proceeds are invested at a reduced risk level.

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