July 2021 DB Plan Funded Status Shows Vulnerability to Interest Rate Risk

According to River and Mercantile’s “US pension briefing – July 2021,” discount rates used to measure liabilities for corporate defined benefit (DB) plans fell nearly 0.15% during July, translating to liability increases of approximately 2% for a typical plan.

Market performance was generally positive for July, with both U.S. fixed income and equities up 1% to 3% for the month. With returns offsetting the effects of increased liabilities, most pension plans’ funded status should have seen little movement over the past month. River and Mercantile notes that whether that movement is positive or negative will depend on a plan’s specific liability profile and mix of investments.

Northern Trust Asset Management (NTAM) found that the average funded ratios of DB plans for S&P 500 companies were largely flat in July, moving from 93.4% to 93.3%. It found that higher liabilities due to lower discount rates offset positive equity returns. According to NTAM, global equity market returns were up approximately 0.7% during the month. The average discount rate decreased from 2.49% to 2.38% during the month, leading to higher liabilities.

Aon also found that S&P 500 aggregate pension funded status remained flat during the month of July, pegging it at 92.4%. According to its Pension Risk Tracker, asset returns were positive throughout July, ending the month with a 1.3% return. The month-end 10-year Treasury rate decreased 21 basis points (bps) relative to the June month-end rate, and credit spreads widened by 12 bps. This combination resulted in a decrease in the interest rates used to value pension liabilities from 2.61% to 2.52%. Aon notes that the majority of plans in the U.S. are still exposed to interest rate risk.

However, other firms that track DB plan funded status found the movement from the end of June to the end of July was slightly negative. And, as River and Mercantile said, other reports showed the degree of loss differed based on a plan’s specific liability profile and mix of investments.

NEPC notes in its “July 2021 Pension Monitor” that equity performance was largely overshadowed by fixed income, likely leading to greater losses in funded status for total-return plans relative to their liability-driven investing (LDI)-focused peers. Based on NEPC’s hypothetical open and frozen pension plans, the funded status of the total-return (open) plan fell 1.8%, while the LDI-focused (frozen) plan declined 0.1% during the month.

LGIM America estimates that pension funding ratios decreased approximately 0.7% throughout July, primarily due to declining Treasury yields. Its calculations indicate the discount rate’s Treasury component decreased 18 bps while the credit component widened 6 bps, resulting in a net decrease of 12 bps. According to LGIM America’s Pension Solutions Monitor, overall, liabilities for the average plan increased 1.7%, while plan assets with a traditional 60/40 asset allocation rose approximately 0.9%.

Both model plans October Three tracks lost ground last month. Plan A dropped 1% in July but remains up 9% for the year, while the more conservative Plan B lost a fraction of 1% last month and remains up more than 2% through the first seven months of the year. Plan A is a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, while Plan B is a largely retired plan (duration 9 at 5.5%) with a 20/80 allocation and a greater emphasis on corporate and long-duration bonds.

Insight Investment estimates that DB plan funded status declined by approximately 70 bps, from 93.8% to 93.1%, during July. However, Shivin Kwatra, head of LDI portfolio management at Insight Investment, points out that “funded status continues to be robust in 2021, averaging over 90% for the year.”

During 2021, the aggregate funded ratio for U.S. pension plans in the S&P 500 has increased from 87.9% to 92.4%, according to the Aon Pension Risk Tracker. The funded status deficit decreased by $114 billion, which was driven by liability decreases of $83 billion, combined with asset increases of $31 billion year-to-date.

Aside from continuing to manage interest rate risk, corporate DB plan sponsors have decisions to make regarding the funding of their plans. Brian Donohue, a partner at October Three Consulting in Chicago, notes, “Pension funding relief was signed into law during March. The new law substantially relaxes funding requirements over the next several years, providing welcome breathing room for beleaguered pension sponsors.”

Michael Clark, managing director and consulting actuary with River and Mercantile, says plan sponsors “will want to consider what the ‘right’ contribution to make to their plan is, given that many sponsors will have substantially reduced or even no required contributions at all.” He adds that plan sponsors with calendar year plans that want to reduce their annual Pension Benefit Guaranty Corporation (PBGC) premiums may find value in making a contribution prior to September 15.