In June, rising interest rates and higher discount rates reduced pension liabilities while causing bond prices to drop. During the same period, stock market declines also contributed to lower equity values and reduced funded status for U.S. corporate defined benefit pension plans.
River and Mercantile’s Pension Risk Briefing points out that unlike some previous months this year that resulted in funded status gains even when discount rates rose and equity markets fell, June saw funded status declines for most plan sponsors. Even though discount rates were up, the resulting declines in liabilities weren’t enough to offset the downturn in assets. “Equity market movements proved too much compared to liabilities during June, bringing funded status levels down for most plan sponsors,” says Michael Clark, a managing director at River and Mercantile. “So far in July we’ve seen rates pull back just a little bit, but equity markets are up largely on signals from the Federal Reserve that more rate hikes are on the horizon and that they are committed to curbing rising inflation.”
According to Aon’s Pension Risk Tracker, the month-end 10-year Treasury rate increased 13 basis points relative to the May month-end rate, and credit spreads widened by 25 bps. This combination resulted in an increase in the interest rates used to value pension liabilities to 4.34% from 3.96%. The Aon report notes that because a majority of plans in the U.S. are still exposed to interest-rate risk, the decrease in pension liability caused by increasing interest rates partially offset the negative effect of asset returns on the funded status of the plans. Pension asset returns were down significantly throughout June, ending the month with a -4.5% return. Consequently, S&P 500 aggregate pension funded status decreased during the month of June from 94.5% to 93.9%.
October Three cites stocks’ falling prices in June as the factor “driving the worst month of the year for pension finance,” according to the firm’s June 2022 Pension Finance Update. Stocks fell more than 8% in June, the update says. A diversified stock portfolio lost more than 20% in the first half of 2022, the worst first half for stock markets since 1970. Both of the model plans October Three tracks lost ground in June. Plan A lost more than 3% but remained up 2% for the year, while the more conservative Plan B lost 1%, ending the first half of 2022 down 1%. (Plan A is a traditional plan with a 60/40 asset allocation, while Plan B is a largely retired plan with a 20/80 allocation and a greater emphasis on corporate and long-duration bonds.)
“Pension funded status for the S&P 1500 fell 2% after a rocky month for equities, and this month, discount rate increases could not make up for those losses,” said Matt McDaniel, a partner in Mercer’s Wealth Business, in a news release. “Stocks saw significant sell-offs in June on continued inflation concerns and interest rate hikes from the Fed. The Fed’s current policy on interest rates appears more aggressive than earlier this year as they increased rates 75 basis points in June and indicated there will likely be more rate increases due to persistent inflation. Unfortunately for pension plans, which tend to have a long interest-rate duration, long-term rates have not increased as much as short-term rates, and in June we saw that impact as funded status dropped despite the sharp increase in short-term interest rates. Plan sponsors are faced with unique market conditions this year and should review their investment policy to ensure they are well-positioned.”
LGIM America’s Pension Solutions Monitor, which estimates the health of a typical U.S. corporate DB pension plan, also estimates that pension funding ratios decreased throughout June 2022. Based on market movements, the average funding ratio is estimated to have decreased to 94% from 97% over the month.
The primary cause for the decline was equity markets’ decline over the month with global equities, represented by the MSCI AC World Total Gross Index, and the S&P 500 falling 8.4% and 8.3%, respectively. Plan discount rates, calculated as a blend of the Intercontinental Exchange Mature US Pension Plan AAA-A and Intercontinental Exchange Retired US
Pension Plan AAA-A discount curves, increased an estimated 30 bps over the month with the Treasury component rising 10 bps and the credit component widening 20 bps. Plan assets with a traditional 60/40 asset allocation decreased 5.7%. The impact of higher discount rates weighed heavily on liability values, but asset performance declined further over the quarter, resulting in a 3.0% decrease in funding ratios over the month.
Sweta Vaidya, North American head of solution design with Insight Investment, says her firm’s model shows that funded status declined by 2.3%, to 98.1% in June from 100.4% in May. Despite another increase in discount rates during the month, funded status deteriorated due to poor equity returns. “While we are acutely aware of the impact of the current interest rate environment on the value of pension liabilities, we must not forget the impact of equity risk on pension assets,” says Vaidya. “We urge plan sponsors to analyze the risk/reward trade-offs in their pension programs within the context of rising rates and volatile equities.”
Quarterly and Half-year Results
June’s results had a negative impact on the second quarter and year-to-date funded status results. MetLife Investment Management’s Q2 2022 corporate pension funded status report analyzed the daily average pension funded status for DB plans at Russell 3000 companies. The results illustrate the impact of investment markets’ recent volatility: “We estimate that as of April 19th the average U.S. corporate pension funded status rose to 104.2%, the highest level in the last 10 years. The average ended the quarter at 98.5%, which is 4.0% below the end of the first quarter. Funded status at March 31, 2022 was the highest of any quarter-end in the last 10 years.”
According to MetLife, pension liabilities in the second quarter decreased by 8.4%, improving funded status during the quarter. Increases in interest rates contributed 8.3% of the improvement, while changes in credit spreads improved funded status by 1.5%. On the downside, benefit accruals decreased funded status by 0.5% (1.8% annually) and interest-cost decreased funded status by 0.7% (2.83% annually). Asset losses resulted in a 12.1% decrease in funded status of which stocks represented -5.4%; bonds, -4.9%; and alternatives, -1.9%.
Aon notes that during 2022, year-to-date the aggregate funded ratio for U.S. pension plans in the S&P 500 decreased to 93.9% from 95.5%. The funded status deficit increased by $12 billion, which was driven by asset decreases of $403 billion offset with liability decreases of $391 billion year-to-date.
Among the key drivers that Aon cites:
- Pension liabilities decreased as interest rates were up significantly across the quarter. Ten-year Treasury rates were up 66 bps over the quarter and credit spreads widened by 35 bps, resulting in a 101 bps increase in the discount rate over the quarter for an average pension plan.
- Conversely, return-seeking assets were down during the second quarter, with the Russell 3000 Index returning -16.7%. Bond performance was also negative during the quarter, with the Barclays Long Credit Index returning -12.6% over this timeframe. Overall, pension assets returned -10.9% over the quarter.
As a result of June’s performance, Wilshire estimates that the aggregate funded ratio declined by 3 percentage points over the second quarter. In June, the monthly change in funded ratio resulted from a 5.4% decrease in asset values partially offset by a 2.7% decrease in liability values. The aggregate funded ratio is estimated to have decreased by 2.9 (to 94.8% from 97.7%) and 1.4 percentage points (to 94.8% from 96.2%) in the second quarter and year-to-date, respectively, but is estimated to have increased by 1.3 percentage points over the trailing twelve months.
Year-to-date, the aggregate funded ratio for U.S. pension plans in the S&P 500 has decreased to 93.9% from 95.5%, according to the Aon Pension Risk Tracker. The funded status deficit has increased by $12 billion, which was driven by asset decreases of $403 billion offset with liability decreases of $391 billion year-to-date.
October Three cites similar mixed impacts during the first half of 2022. Treasury rates increased 1.25% while corporate bond yields rose 1.75%. As a result, bonds lost more than 1% during June and ended the first half of 2022 down by between 11% and 20%, with long-duration and corporate bonds performing worst. The upside to higher rates has been reduced plan liabilities: Pension liabilities decreased 2% to 3% in June and are now down by between 15% and 23% for the year, with long-duration plans seeing the largest declines.
From a slightly longer-term perspective, though, the overall positive trend in DB plans’ funding remains intact. Willis Towers Watson calculates the WTW Pension Index for 300 companies. According to the firm’s Pension Finance Watch report for the period ending June 30, 2022, the aggregate funded ratio is 95.7%, which is the same ratio as year-end 2021 and significantly higher than the 87.8% ratio of December 31, 2020. Northern Trust’s data reflects similar results, improving from 86% on December 31, 2021, to 96.3% as of June 30, 2022.
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