The rise in interest rates over the past couple of years has caused many headaches for most investors. Stocks experienced significant losses last year, while bonds – normally seen as the safer part of a portfolio – suffered their worst performance in history. There has been almost no place to hide, aside from inflation hedges like commodities. However, one category of investors in particular has seen their financial statuses improve almost across the board: corporate pension plan sponsors. According to Millman, a data aggregator for the top 100 corporate pension plans in the United States, corporate pension plans have seen their average funded status improve from a low of almost 80% in July 2020 to 104% at the end of October 2023. Funded status is a measure of a pension’s health and is calculated as the ratio of the plan’s asset portfolio to the present value of its liability portfolio. Millman projects that the average funded status of the top 100 corporate plans will improve to 105% by the end of next year.
While this increase in the financial health of a specific type of investor – compared to most who are facing losses – seems a bit odd at first, there are a few explanations of what’s going on beneath the surface. The most impactful is the change in the “discount rate,” which is the rate at which an asset portfolio can be invested in near-risk-free assets to hedge future cash flow needs. In these plans, the discount rate is generally equivalent to the yield on the corporate bonds of the plan sponsor. As interest rates rise, the discount rate also rises, making it such that the present value of the liability portfolio (the denominator of the funded-status ratio) decreases. Another reason is likely the presence of private investments on the asset side of the equation. Asset classes such as private equity have become an increasingly attractive option for pensions in the previous low-rate environment, especially those which have been underfunded, due to the higher expected return in these risky assets coupled with the lower reported volatility due to infrequent pricing. This lower volatility means that the pension’s asset portfolio is slower to account for the rise in interest rates and the potential knock-on effects to the underlying businesses. The effect on the funded-status ratio is that the asset portfolio (the numerator of the equation) is slower to price in downside risks. These two effects – the discount rate and the slow reaction of the asset portfolio due to the presence of illiquid assets – cause the liability side of a portfolio to fall faster than the asset side of the portfolio. So, like most other investors, even though pension plans have seen losses over the past couple of years, their funded statuses have shown improvement.
The confluence of a rapid rising rate environment and the large allocation of pension assets to non-public assets has resulted in what looks like a massive improvement of financial position in corporate pensions. However, it’s quite clear that there are some huge risks in taking that at face value. A similar type of risk came to light during the Global Financial Crisis when a stock market crash was followed by an environment where interest rates fell precipitously, leading to a historic decrease in aggregate funded status across the Millman 100. Larger public pensions across Canada have been reducing exposure to private equity this year as fixed income investments offer higher returns, making it such that these institutions don’t need to reach as far out on the risk spectrum to hit their return goals. We’d hope that corporate pension plan sponsors are following suit, especially those operating defined benefit plans. As Edward Qian of Panagora pointed out in this 2012 article, the equity risk premium to which many of these private investments are inherently tied (and often levered) is correlated with corporate sector health. And so, if equity risk were to cause a negative impact to funded status, it is likely that the plan sponsor, which is often the corporation itself, is also suffering, making it difficult to cover the deficit. This, along with the fact that the equity risk premium generally shrinks during higher rate environments, means that pensions may need a better solution than piling into equity-centric investments during low-rate environments.
A more targeted approach for pensions involves taking a liability-driven approach and ensuring that risks within the liability portfolio are matched within the asset portfolio. While many pensions embrace the liability-driven approach via hedging some of their risk through a laddered fixed income portfolio, the growth portion of the portfolios that serve the role of improving funded status tend to be quite heavy in equity risk. We recently published a research note that explored how risk-allocated, multi-asset portfolios have a higher correlation with risk factors that exist in the liability portfolios of pension plans. When utilized within the growth allocation of a pension portfolio, our analysis showed better funded-status outcomes and less shortfall risk when taking a risk-parity approach. Neuberger Berman also put out an interesting paper in 2020, which came to similar conclusions. It also showed that such a portfolio construction displayed convexity with respect to extreme interest rate volatilities, meaning that it outperformed a simplistic growth sleeve allocation both during periods that the present value of liabilities gained significantly and fell significantly. While both our research and Neuberger Berman’s are a bit more on the technical side, the bottom line can be summarized as follows: a more targeted approach to funded-status improvement via more explicitly matching the risks in a pension’s liability portfolio can be achieved through a portfolio construction methodology that utilizes risk allocation to different macroeconomic factors. This in turn should provide more robust outcomes and cause less stress for plan sponsors, regulators, and plan beneficiaries alike.
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