Hopping Off the Roller Coaster

Corporate pension plan sponsors that have maintained pension plans for the last couple of decades are all too familiar with the pension funded status roller coaster. The opportune time to hop off the funded status roller coaster (de-risk the plan), is at the peak, when funded ratios are at their highest levels. However, predicting the peak is not an exact science. Recent strong equity performance and rising interest rates have pushed funded levels above 100% for many plans for the first time in 15 years. With funded ratios back to historical high levels, plan sponsors that are not on a de-risking glidepath may face another important decision: whether to stay on or hop off the roller coaster now.

A brief look back at history

As indicated by the Milliman Pension Funding Index, pension plan funded status had major peaks above full funding in the early 2000s and then right before the 2008 financial crisis, following which funded ratios fell dramatically.

Figure 1. Milliman 100 Pension Funding Index

As of 12/31/2021

Source: Milliman

View accessible version of this chart.

While equity markets have been climbing in recent years, lower interest rates which kept liabilities higher have kept funded status below prior peaks. The tables have recently turned. In the last 15 months (end of calendar year 2020 through end of March 2022), funded ratios are up 5-20% depending on plan type, with most of the improvement driven by positive equity performance and rising interest rates that have decreased the value of the liabilities.

Following the 2008 financial crisis, many sponsors started the process of de-risking their plans through structured glidepaths that shift equities to liability matching bonds as funded status improves. This approach created a much smoother ride to reaching funding targets as the plans approached the peak fully funded position. Effectively, these plans have hopped from a choppy roller coaster to one with a smoother path. However, other plan sponsors have been waiting for dramatic funded status recovery to act and, after the recent improvements, may be contemplating a near-term shift.

Evaluating the roller coaster

Funded ratios are much higher recently than they have been in the last 15 years. Some plan sponsors reason that high current and expected inflation, along with Federal Reserve (Fed) rate hikes, means the peak is not yet here. Inflation is generally viewed as positive for corporate pension liabilities since the plan benefit amounts paid are often flat and inflation could help drive up overall interest rates, lowering liabilities.

In the first three months of 2022, discount rates used to measure pension liabilities are up 80-90 basis points, primarily driven by increasing interest rates. As plans continue to evaluate whether it is a good time to get on the smoother ride, consider what is needed for the trend to continue upwards:

Equity markets would need to hold their weight with a reminder that the largest historical drops in funded ratio occurred during equity market corrections.
Long interest rates would need to continue climbing, given the Fed only controls the shorter end of the yield curve. Economic growth, global demand for U.S. Treasuries and inflation factors would all need to work together for long rates to continue the upward trend.

Choosing the smoother ride

Plan sponsors that have already de-risked have been focused on a more purpose-driven investment strategy versus a return-driven strategy. A purpose-driven strategy keeps an eye on the future desired state (could be hibernation or termination for the pension plan) and puts a structured glidepath in place to get to the desired position. Plans sponsors that have yet to make the shift could have a near-term opportunity to start de-risking by selling equity and buying cheaper bonds before the roller coaster makes another surprising drop.

For more information, contact Kimberlene Matthews, FSA, EA, CFA, Managing Director, Pension & Enterprise Solutions, at kimberlene.matthews@pnc.com.

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