US Corporate Pensions Get Hit in 2020?

Michael Katz of Chief Investment Officer reports that the funded status of US corporate pensions dropped last year despite robust returns:

Funding for the 100 largest corporate pension plans in the US declined $50 billion last year as their aggregate funding ratio slipped to 88.2% at the end of the year from 89.8% at the end of 2019, according to consulting firm Milliman.

After sharp investment declines in the first quarter, asset returns rebounded strongly during the rest of the year. That rebound helped offset the funded status deterioration that was a result of the discount rates used to value pension liabilities continuing to fall. The funded status deficit of the 100 plans tracked by the Milliman 100 Pension Funding Index (PFI) was at $234 billion at the end of December, which was the lowest monthly funded status deficit during the year.

The discount rates for the plans in the Milliman 100 fell 74 basis points (bps) to 2.46% at the end of 2020 from 3.2% at the end of 2019, and the discount rate at the end of 2020 was the lowest year-end discount rate and second lowest monthly discount recorded in the 20-year history of the PFI.

Net asset performance for the plans was 11.72% for the year, easily beating the expected annual investment gain of 6.5%. And although this increased plan assets by nearly $125 billion for the year, plan liabilities increased $175 billion due to falling interest rates.

“Year-end discount rates have declined in seven of the last 10 years, hitting a new record low in 2020,” Zorast Wadia, author of the Milliman 100 PFI, said in a statement. “However, asset returns for the Milliman 100 plans have exceeded return expectations in seven of the last 10 years as well and have been limiting funded status erosion.”

Wadia added that with the new year here, plan sponsors will likely be monitoring the new Congress and the Biden administration for corporate tax policy changes that could impact the pension funding environment, such as an extension of interest rate relief under the Pension Protection Act.

Milliman forecast that if the plans in the index were to earn the expected 6.5% median asset return, and if the discount rate of 2.46% holds steady during 2021 and 2022, their funded status would increase to 92.2% by the end of 2021 and 96.5% by the end of 2022. The forecast assumes aggregate annual contributions of $50 billion for 2021 and 2022.

The firm said that under an optimistic forecast with interest rates rising to 3.06% by the end of 2021 and 3.66% by the end of 2022, with 10.5% annual asset gains, the funded ratio would climb to 104% by the end of 2021 and 123% by the end of 2022. However, under a pessimistic forecast with the discount rate falling to 1.86% at the end of 2021 and 1.26% by the end of 2022, with only 2.5% annual returns, the funded ratio would decline to 81% by the end of 2021 and 75% by the end of 2022.

This is an important topic which I'd like to spend some time on today.

First, pensions are all about managing assets and liabilities. What this article highlights is even when asset returns are robust, if rates drop and liabilities explode, the funded status of corporate plans deteriorates.

Why is that? Because the biggest determinant of future liabilities is interest rates and a drop in rates, especially from a record low level, will disproportionately hurt pensions.

In finance parlance, the duration of pension liabilities (they go out 75+ years) is a lot bigger than the duration of assets, so even if asset values rise, if rates drop from record low levels, it will mean liabilities will go up a lot more than assets.

And remember, unlike US public pension funds which use projected returns to discount their future liabilities (anywhere between 6.5% to 8%), US corporate pensions use AA bond yields to discount their pension liabilities as required by GAAP accounting standards.

As GSAM noted back in June 2020, not all liabilities are created equal, "plan sponsors to understand the drivers of funded status change especially during stressed credit environments and know what, if anything, can be done to protect funded status."

What this means in practice is unlike US public pensions, US corporate plans manage their assets and liabilities a lot tighter and they generally do not take the same risks as public plans across public and private markets.

In fact, most of them are looking to de-risk their pension plans and do away with them altogether, a fact which just exacerbates the long term trend of pension poverty in the US.

But it's important to note many large corporate plans, while similar, are vastly different in their approaches. For example, this Russell Investments note from 2015 on asset allocation changes at large US corporate plans notes the following:

[...] discretionary contributions above the mandated minimum at Raytheon and United Technologies, but full advantage of funding relief taken by GE and some others; aggressive adoption of liability-driven investing (LDI) at Ford and GM, but a reduction in fixed income allocation at Lockheed Martin; risk transfer activity (offering lump sum payouts) at United Technologies and Boeing. A clear case of each corporation looking for the strategy that fits.

Some large US corporate plans allocate more aggressively to bonds as part of their LDI approach, others to alternative investments like hedge funds and private equity, it varies depending on the maturity and funded status of the plan.

Still, one thing is for sure, US corporate plans manage risks a lot tighter than US public plans because they need to control the cost of their plans as shareholders scrutinize and penalize them if they don't.

But US public pensions have intrinsic structural advantages over US corporate plans, many of which were outlined in a comment I posted from Ben Meng, CalPERS' former CIO, earlier this week. 

The truth is one can make the case the AA bond yield US corporate plans use to discount future liabilities is too low (a few basis points over long term Treasury bond yields) just like many argue the projected return assumptions US public plans use to discount their future liabilities are too high and unrealistic given where long term Treasury yields are.

The most important point I want to make in this comment, however, is that the drop in long government bond yields impacts the funded status at all pensions, public and private, all over the world.

And if rates go down a lot from record low levels, even if assets rise because the Fed and other central banks are increasing their balance sheets up to wazoo, it spells trouble for pensions.

The perfect storm is when rates drop significantly and assets plunge, that will really clobber pensions as it did back in 2008.

Hopefully policymakers are going to succeed in avoiding such a scenario by keeping their focus on monetary and fiscal stimulus, but there are no guarantees.

And many chronically underfunded public plans are one crisis away from passing the point of no return. That is what really worries me. 

Alright, let me wrap it up there, if you have anything to add, feel free to email me at LKolivakis@gmail.com.

Below, Ira Epstein of Linn & Associates explains why he thinks negative rates aren't coming to the US. 

Mr. Epstein makes a lot of excellent points but my fear is in a post-pandemic world with anemic growth, many central banks are in negative territory or are considering it, and the US might not avoid such a scenario either. And if deflation hits the US, all bets are off and negative rates are coming. 

And if US rates go negative, US and global public and private pension liabilities will explode up.

Don't worry, long before that happens, I'm sure the Fed and other central banks will be buying US stock ETFs, especially technology ETFs. We live in very interesting times!