Higher Discount Rates Offset Lower Equity Values in August

The firm’s model shows that funded status among U.S. corporate pension funds improved by 0.7 percentage points, to 99.0% in August from 98.3% in July, as a 3.7% decrease in asset value was offset by liabilities’ 4.5% decrease. Discount rates reversed course again and rose over the month, decreasing the value of both pension liabilities and fixed-income assets. The average discount rate rose by 36 basis points to 4.51% during the month from 4.15%. (The change in rates was primarily due to change in the as spreads remained flat during the month.)

Equity returns were also weak, but they were offset by a drop in liabilities, which caused funded status to improve overall. “Note that discount rates are back near their June levels, representing about a 170 bps increase since the beginning of the year,” Vaidya said in a statement. “The Fed has stressed that rates are likely to continue to rise significantly, which would further improve pension funded status but also put strain on economic growth and the equity markets. Pension investors may be running out of time to ‘recession-proof’ their plans!”

Agilis’ Pension Watch for August says that discount ended the month about 0.35% higher than end of the July and expected that funded status for most pension plans will remain level with market losses matching liability gains.

“Rates jumped up at the end of August following the Fed’s Jackson Hole meeting. Where markets were expecting rate increases to subside in early 2023, they are now pricing in late 2023 timing for potential rate cuts assuming that inflation comes back down to reasonable levels,” said Agilis Managing Director Michael Clark in a statement. “While it looks like inflation may have crested for now, it’s still going to be higher than the Fed’s target for months to come which is going to lead to continued volatility in equity markets for the foreseeable future.”

A Wilshire release on August pension funding says the aggregate funded ratio for U.S. corporate pension plans increased by an estimated 1.0 percentage point month-over-month in August to end the month at 96.2%. The monthly change in funded ratio resulted from a 5.0% decrease in liability values mostly offset by a 4.1% decrease in asset values. Although the aggregate funded ratio is estimated to have stayed constant year-to-date, Wilshire estimates it increased by 2.1 percentage points over the trailing twelve months.

August saw significant declines for both asset and liability values, according to Ned McGuire, managing director with Wilshire. The liability value experienced the second largest monthly decline this year, after April’s decline, with discount rates estimated to have increased by approximately 40 basis points. “Moving nearly in tandem with the liability value, the asset value decrease of this month was the seventh out of the past eight calendar months, but only the fourth steepest decline,” said McGuire in the release. “Despite this month’s asset value decrease, the larger decrease in liability value resulted in August’s estimated month end funded ratio increasing to the same level seen at the beginning of the year,” McGuire added.

LGIM America’s Pension Solutions Monitor, which estimates the health of a typical U.S. corporate defined benefit pension plan, also estimates that pension funding ratios moderately increased throughout August. Based on market movements, the average funding ratio is estimated to have increased to 95.6% from 95.0% over the month.

Equity markets had a weak month with global equities, as measured by the MSCI AC World Total Gross Index and the S&P 500, which dropped 3.6% and 4.1%, respectively. Plan discount rates were estimated to have increased by roughly 43 basis points over the month, with the Treasury component increasing 40 basis points and the credit component widening slightly by 3 basis points. Plan assets with a traditional 60/40 asset allocation decreased 3.3%; however, the fall in liabilities outweighed the drop in assets over the month, resulting in a 0.6 percentage point increase in funding ratios. (The Pension Solutions Monitor assumes a typical liability profile using an approximate duration of 12 years and 60% MSCI AC World Total Gross Index/40% Bloomberg Barclays US Aggregate Index (“60/40”) investment strategy, and incorporates data from LGIM America research, ICE indices and Bloomberg.)

During August, the Milliman 100 Pension Funding Index funded ratio, which analyzes the 100 largest U.S. corporate pension plans, climbed to 106.4% as of August 31 from 104.8% on July 31. The funded ratio improvement was driven by an increase of 36 basis points in the monthly discount rate. The PFI projected benefit obligation lessened by $65 billion as discount rates rose to 4.61% from 4.25% in the month. Meanwhile, the market value of assets fell by $46 billion because of August’s 2.47% investment loss.

“Despite year-to-date investment losses of 11.6% through the end of August, the funded status surplus for these plans climbed to $91 billion,” said Zorast Wadia, co-author of the PFI, in a news release. “This gain is attributable to the steep rise in discount rates, 36 basis points in August and 181 basis points year-to-date.”

October Three’s pension finance update notes that results for its model funds were mixed during August, as higher interest rates offset the impact of falling stock markets. Both model plans the firm tracks were close to even last month: Plan A improved less than 1% and is now up almost 5% for the year, while the more conservative Plan B lost a fraction of 1% in August and is now down 1% through the first eight months of 2022. (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, with a greater emphasis on corporate and long-duration bonds.)

Interest rates jumped 0.4% in August, producing negative returns for bonds. A diversified bond portfolio lost 3% during August and is now down 12% to 20% for the year, with long-duration and corporate bonds performing worst. The traditional 60/40 portfolio lost 4% during August and is now down 16% for the year, while the conservative 20/80 portfolio lost 3% last month and is also down 16% through the first eight months of 2022.

Corporate bond yields rose 0.4% during August, ending the month at their highest level in a decade. As a result, pension liabilities fell 3% to 4% last month and are now down 16% to 22% for the year, with long-duration plans seeing the largest declines, according to October Three.

October Three’s update also notes that while it has been a brutal year for stock markets, pension sponsors have been insulated from falling stock prices by higher interest rates. The net effect has been neutral to modestly positive for most pension plans this year.

In contrast to other firms’ findings, the Aon Pension Risk Tracker shows that S&P 500 companies’ aggregate pension funded status decreased during the month of August to 93.0% from 93.6%. Pension asset returns were down significantly throughout August, ending the month with a 3.2% loss. The month-end 10-year Treasury rate increased 48 basis points relative to the July month-end rate and credit spreads narrowed by 21 basis points. This combination resulted in an increase in the interest rates used to value pension liabilities to 4.23% from 3.96%. Given that 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 plan, Aon’s update notes.

Funding ratios have also declined year-to-date, according to Aon’s pension tracker, which estimates that during 2022, the aggregate funded ratio for U.S. pension plans of S&P 500 companies has decreased to 93.0% from 95.5%. The funded status deficit has increased by $29 billion, which was driven by asset decreases of $402 billion offset with liability decreases of $373 billion year-to-date.

WTW’s Pension Finance Watch report also cites a decline in funded status for August. The WTW Pension Index declined slightly for the month, remaining at a level comparable to July’s and well above June’s, according to the report. August’s change was due to negative investment returns, which were almost completely offset by decreases in liabilities. The end-of-August index level of 96.9% reflects a decrease from 97.0% for July.

The equity portion of the WTW benchmark portfolio, a hypothetical pension plan invested in a 60/40 portfolio, lost 4.0% in August, with the international equity asset class incurring the largest decline. The fixed-income investments of the tracked benchmark portfolio also had a negative return at 2.5%, with long corporate bonds experiencing the largest losses. Yields on long high-quality corporate bond indices increased an average of 35 basis points. These were followed by increases in long Treasury rates. Yields on 10- and 30-year Treasury bonds increased 48 and 27 basis points, respectively.

Looking ahead, October Three’s update notes that pension funding relief was signed into law last March, and additional relief was provided by November legislation. The new laws substantially relax funding requirements over the next several years, providing welcome breathing room for pension sponsors. Discount rates moved up 0.4% last month, reaching the highest levels seen in a decade, and the firm expects most pension sponsors will use effective discount rates in the 4.5% to 4.8% range to measure pension liabilities right now.

Milliman’s analysis provides two potential intermediate-term scenarios. With rising interest rates (reaching 4.81% by the end of the year and 5.41% by the end of 2023) and asset gains (9.9% annual returns), the funded ratio would climb to 111% by the year’s end and 125% by the end of 2023. Under a pessimistic forecast (4.41% discount rate at the end of the year and 3.81% by the end of 2023, and 1.9% annual returns), the funded ratio would decline to 103% by the end of the year and 94% by the end of 2023.