Now It Is About Protecting Healthy Funded Levels

Corporate defined benefit pension plan sponsors have a singular opportunity to evaluate if their plans are in a position to offload liabilities using pension risk transfer or allocate to strategies with less risk, including liability-driven investing, reviewing their options to best provide pension benefits to the participants to whom they were promised at the lowest cost for the company going forward.

Separate Milliman and Principal Asset Management research on pension plan funding finds sponsors have room to now accelerate de-risking—as the funded status of many has improved to reach fully funded and near-to-fully funded status—to protect funding levels.

The funded status of the average U.S. corporate pension plan “sits around [the] 105% level, so it’s over funded,” explains Owais Rana, head of investment solutions at Principal Asset Management.

“It is therefore an opportune time for pension plan sponsors to take risk off the table, particularly the investment risks to begin with, and then start considering whether it makes sense to further de-risk their balance sheets by embarking on a pension risk transfer strategy or maintaining the obligations on their balance sheets, also known as hibernation by de-risking their investment strategy.”

State of PRT Market

The U.S. pension risk market was estimated to have $14.6 billion, in the first quarter of 2024 compared to the previous Q1 record of $6.3 billion in 2023 and nearly triple the 2022 figure of $5.3 billion, finds a Legal & General Retirement America May 2024 market update.

The pension risk transfer market is expected to remain strong, according to Cerulli Associates research.  

“Over the last handful of years, we’ve seen pretty historic pension risk transfer activity, and across the board, [survey respondents] felt like it was going to continue, regardless of where interest rates have gone,” says Chris Swansey, associate director, institutional, at Cerulli Associates.

More than two-thirds of plan sponsors (69%) said they are at least somewhat likely to de-risk over the next 24 months, found Cerulli in research conducted in the second quarter of 2023, published in May. 

“Over the last handful of years, we’ve seen pretty historic pension risk transfer activity, and across the board, everybody felt like it was going to continue, regardless of where interest rates have gone,” adds Swansey. “Funded statuses have improved dramatically, and a lot of plan sponsors are looking at fully funded or surplus funding. So that kind of creates an opportunity … we’ve also had a number of new entrants into the insurance space, and that’s driven down costs.”

Pension Funded Status Research

In 2023, three of the top 100 U.S. pensions reached a funded ratio greater than 140%; one achieved between 135% to 140%; and two plans each were within funding ratios of 130% to 135%, 125% to 130% and 120% to 125%, according to Milliman research.

Almost 50, nearly half of the companies within the Milliman data set reached fully funded levels, explains Zorast Wadia, principal and consulting actuary at Milliman.

“[It] only improved in the first four months of 2024,” he says. “So, I would think that now more than half of the largest U.S. plan sponsors are at or above full funding levels.” 

In total, 69 plans are between 95% and above 140%, finds the Milliman 2024 Corporate Pension Funding Study. The study tracks public companies with the largest DB pension plan assets for which a 2023 annual report was released by March 10, 2024.

“[It’s] an important place to be for pensions because we haven’t seen these types of funding levels for a decade and a half,” explains Wadia, co-author of the study. 

In 2023, the average funded ratio of the 100 pension plans tracked by Milliman decreased slightly to 98.5% from 99.4% at the end of 2022 and the 7.2% investment return was not enough to pace the growth

“A deficit of $19.9 billion this year put corporate DB plans of the Milliman 100 companies within striking distance of achieving full funding,” Milliman researchers wrote.

In 2023, the pension deficit of the Milliman 100 companies rose to $19.9 billion from $8.5 billion, Milliman reported.

For sponsors, with healthy funded levels the focus often shifts to measures to protect funding, says Wadia.

“The whole emphasis of [corporate DB sponsors] should be right now to make sure to lock in these gains: You don’t want history to repeat itself, like in the late [19]90s [when] pension plans were in a great position,” but did not protect the gains, he says.

Corporate pension funds should learn from past mistakes, Wadia adds.

Timing

Rana and Sri Reddy, senior vice president of retirement and income solutions at Principal Financial Group, say the timing is right for corporate DB sponsors by swapping out equity-like exposure for fixed income assets, Rana wrote in a post online, earlier this year.

“What I ask CFOs and CEOs is, ‘What is the relative size of your pension obligations relative to your current earnings?’” says Reddy.  “That’s a good proxy” for the risk the pension funding declining could add to a business.

The de-risking strategies available to sponsors include lump sum payments, particularly to participants who are near retirement; and full or partial pension risk transfers, according to Rana. 

“From my perspective, [de-risking in ways we recommended] would allow plan sponsors who have been waiting for this point to sleep well at night,” explains Rana.

For sponsors, following Principal Asset Management’s recommendation to de-risk would almost entirely “defease most of their investment risks relative to liabilities,” he adds.   

With the blueprint, “[plans] haven’t eliminated [the investment risk]—[because] the only way to do that is with a pension risk transfer, but they have defeased a significant amount of risk out of the system and now the companies can concentrate on their actual business as opposed to spending ,” Rana says.  

Wadia agrees that de-risking portfolios will require exploring reallocating plan assets to lower-risk assets and liability-driven investment strategies. 

“LDI is the strategy that makes sense if you want to sleep well at night, if you’d want to minimize interest rate risk and investment return risk,” he says.

Learning their lessons from the past, sponsors do not want to surrender healthy funded level gains, Wadia adds.

“[LDI] is essential as your funding status improves, you want to move away from risky investments, i.e., equities and go into fixed income,” he explains.

Using LDI, sponsors allocate to fixed income portfolios, “matching your liability payout stream—your [plan’s] unique payout stream—to your plan.”

Plans with full funding or that are close to fully funded, de-risking to lock-in gains will address, Rana adds.

“[Sponsors] need to seriously start to match the interest rate risk of the liability and sell some of that equity risk to reduce the overall mismatch between assets and liabilities,” says Rana.

He clarifies that while the Federal Reserve may start to cut interest rates this year, that would have little effect because “short-term rates will have very little to no direct impact on liability valuations,” adds Rana.

Factors to Consider

Corporate sponsors, protecting healthy funded levels, should base their decisions to de-risk, reallocate or offload liabilities on the overall health of their plan, says Rana.

“[There is] no one factor … there are a few factors, which are … going to be very unique and specific to each plan sponsor,” he explains.

Open plans that are accruing benefits require a distinct strategy from a closed plan, for example, explains Wadia.

“Do you still have a highly leveraged final average pay plan design that many would consider a dinosaur plan? These plans have very aggressive accrual patterns, and are highly leveraged, so participants entering later years of service—the benefits can really move off the charts and so with the newer types of plan designs like cash-balance plan designs, and variable-annuity plans, there’s a deeper level of risk sharing between the plan participant and the sponsor.”

The interest rate sensitivity of a plan’s liabilities is also an important factor to consider, adds Rana.

The longer-dated obligations are the more sensitive the assets are going to be to interest rates, Rana says, “hence, [sponsors] must explore the LDI component far more than an obligation that’s going to be of a two-year duration, for instance [because] the interest rate risk [of the asset] is not that much.”

Another factor, “and one of the most important ones,” is the strength of the company and its ability to withstand bad market events, says Rana.  

Declining equity markets and lower “long-end” interest rates will affect sponsors, flipping sponsor’s funded status toward a less healthy position, he adds.

“Are companies in a position to bear that risk, which translates into future contributions that they will have to make into these plans? A lot of the companies that have defined benefit pension plans have been industrial companies. If you look at the universe of those companies that have the strength to withstand these events, [it] is going to be very low, which means that they are better off de-risking … as opposed to being to be forced to divert capital away from shareholders into a pension plan in the future,” Rana says.