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Why Has My Pension Funding Improved (and Why Hasn’t It Done Better)?

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David Phillips, CFA, ASA, EA

Director, Liability-Driven Investment Strategies

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In early 2021, we’ve seen a drastic turnaround in the value of US pension plans. Understanding why is key to managing both expectations and performance the rest of this year and beyond.

Over the past decade, there has been a constant stream of headlines regarding the dire state of corporate pension plans in the United States. It is noted repeatedly that projected pension payments are much higher than the assets held to fund them. However, the early months of 2021 show how quickly this situation can change.

The actuarial consulting firm Milliman® produces a monthly report on the financial health of the largest 100 US corporate pension plans on a combined basis. So far, 2021 has seen an astonishing degree of improvement in the funded status of these plans. Consider that at year-end 2020, the funded ratio–the ratio of a pension’s assets to its projected liabilities–for these plans was 90.3%, which represented a funding shortfall of roughly $190 billion. Three months later, the funded ratio had improved dramatically to 98.4%, representing a shortfall of a mere $29 billion. The chart below shows just how rapid this recovery was.

Milliman® 100 Pension Funding Index pension-funded ratio

Milliman 100 Pension Funding Index pension-funded ratio chart

Source: Milliman® Pension Funding Index, April 2021.

As we see toward the right end of the graph in this chart, the pace of recovery in the financial health of corporate pensions has been breathtaking. This recovery has left many asking questions about their own plan’s experience over the course of 2021.

What drove this improvement?

First and foremost, what drove this rapid reduction in the combined deficits of the Milliman® 100? Certainly, equity assets have provided strong returns over the past year.  Indeed, through March 31, the S&P 500® has increased by 6.2% year-to-date. This is not the primary reason for improvement in funded status, however. While the numerator of the funded ratio is the value of the pension plan’s assets, the denominator is the present value of its liabilities. The recent recovery in funded status has much more to do with the latter value than with oversized equity returns.

Recall that pension liabilities are discounted to reflect current interest rates, so as interest rates fall, plan liabilities increase. On the contrary, if interest rates rise, liabilities decrease. The following chart compares the S&P 500® with the 10-year Treasury rate and gives a hint as to what is driving the current rally in funded status:

S&P 500® and 10-year Treasury, 03/31/2011 through 03/31/2021

S&P 500 and 10-year Treasury, 03/31/2011 through 03/31/2021chart

Sources: S&P, DJI Board of Governors, 3/31/2021.

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In general, over the past decade—but before the COVID-19 pandemic—equity markets rallied while interest rates ground lower. This has resulted in positive returns for equity and fixed-income assets but has also resulted in liabilities increasing in value.  Given that most plans were underfunded, the gains in their asset portfolios were more than offset by the growth in their liabilities. 

However, the past 12 months have been exceptional compared with the rest of the decade in that equity markets have rallied while interest rates have increased. That is, equity assets have risen sharply, and liability values have fallen sharply. This combination of factors more fully explains the rapid recovery in funding ratios for US corporate pension plans.

Why didn’t I see more improvement?
Plainly, the Milliman®; 100 is an indicator of the overall health of the US corporate pension market, so the performance of this index will not be matched exactly by every corporate plan. Looking at funded ratio improvement over the course of Q1, plan sponsors should consider three factors when examining why their plans saw better or worse funding improvement: 

Size of equity exposure. As shown in the second chart, over the past 12 months, equities have done spectacularly well. If a plan held a larger portion of its asset portfolio in equities than the average asset allocation in the Milliman® 100, it would’ve seen a moderately better improvement in its funded ratio. 

More revealing, however, is to examine the amount of equities as a percent of liabilities. If a plan had allocated 70% of its assets to equities, but its funded ratio was 70%, equities would only account for 49% of its liabilities. In such a situation, the equity market impact would be dwarfed by the change in the liability valuation; therefore, asset allocations need to be considered in conjunction with initial funded status when examining funded status changes.

Size of fixed-income exposure or LDI mandates. On the flip side, rising rates have caused many fixed-income asset classes to decline in early 2021. As such, plans with larger allocations to bonds will see a slower pace of improvement in their pension’s surplus. This is an important consideration for those plans that have moved some portion of their asset portfolio to an explicit liability-driven investing (LDI) framework. The goal for an LDI mandate is to reduce surplus volatility, typically by hedging interest rate exposures in the liability stream, which provides a smoother funded status ride through time. Accordingly and by design, in times of rising rates, LDI assets fall in value to offset the economic benefit of a reduced liability valuation. The more a plan has progressed with an LDI program—more generally, the larger its allocation to bonds—the less improvement seen in funding status in 2021. 

Liability attributes and funded status. As much of the improvement in funding status has come through the decline in liability values, differences in a plan’s future benefit payments can lead to material deviations in funding improvements. That is, plans with shorter liabilities than the Milliman® 100 should expect to see less of a decrease in their liabilities, which translates into a smaller improvement in funding status. Also, for two plans with identical liability streams, the plan with the larger initial deficit should expect to see less improvement in its funded ratio. Why? Because each month’s benefit payment decreases the assets at a faster rate than it decreases the liabilities, resulting in a worsening deficit, all other things being equal.

The bottom line
This rapid improvement in funding status has not gone unnoticed. As shown in the first chart, corporate pension plans represented by the Milliman® 100 are the healthiest they’ve been since 2008. But this health is conditioned on equity markets maintaining their lofty valuations and interest rates maintaining their higher levels. Many clients and consultants are not convinced that these will hold true and are working to lock in the current funding levels by moving more of their plan assets to an LDI framework. In addition, many pension plans maintain strategic asset allocation glide paths that enforce discipline into LDI de-risking. By holding a portfolio of assets that moves more in concert with their liabilities in reaction to future interest rate changes, they are looking to reduce the range of future outcomes in the financial health of their pension plan while preserving the current funded status before it potentially fades away because of a market correction or resumption in the decline of interest rates.

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