Corporate pension trends and topics: What’s top of mind for 2024?

To help US corporate defined benefit (DB) plans prepare for the coming year, we offer this overview of timely investing, funding, and accounting issues.

Funded ratios, derisking trends, and long bond demand 

The aggregate funded ratio for US plans was 99% as of 29 December 2023, up only slightly from 97% at year-end 2022 as the recent drop in interest rates has caused liability growth to offset equity strength.¹ For a substantial derisking wave to take hold, we think funded ratios would need to climb to at least 105%, which would require a combination of positive equity returns and higher interest rates. Looking beneath these big-picture estimates, we find that plan sponsors with smaller or no liability-hedging allocations and larger return-seeking allocations generally made up more funded-ratio ground in 2022 and the first half of 2023 than those further along in their LDI adoption. This has spurred some idiosyncratic derisking into liability-hedging assets, particularly by plans that are newer to LDI. More recently, however, we’ve noted some incremental derisking activity in LDI-oriented plans.

Long bond demand from corporate DB plans is currently somewhat muted, but we estimate that about $400 billion – $500 billion in pent-up demand is on the sidelines, waiting for higher funded levels. On the supply side, hesitation to lock in high long-term interest rates led to lower-than-typical credit issuance in 2023, which could generate a demand/supply mismatch should derisking resume more broadly. We think plan sponsors can prepare for this by ensuring they have a line-up of credit managers ready to take inflows, checking funded levels frequently, and considering a role for hedging assets that can widen the opportunity set beyond long credit, such as intermediate credit, global credit, and private placements.

An end to the downward trend in ROAs?

Corporate plans’ return on asset (ROA) assumptions, which have trended down for the past 15 years, leveled off in 2022. The average ROA assumption reported by Russell 3000 companies at year-end 2022 was 5.2%, unchanged from the average in 2021.² We believe ROAs may stay level or even increase in 2023 annual pension footnotes, reflecting the higher yields and lower asset valuations we saw going into 2023. However, a pickup in derisking activity, which, as noted, has been fairly muted, could be a partial offset to any increase in ROAs as plans reflect higher allocations to fixed income. More thoughts on ROAs and other pension accounting topics, such as the potential for higher pension expense, are in our paper: Setting ROAs for 2024: A guide for US corporate and public plans.

Contribution concerns and LDI implications

Higher contribution requirements or the end of contribution holidays could hit in the 2024 plan year. Based on our estimates, PPA (Pension Protection Act) funded ratios are expected to be a notch above fully funded in 2024, similar to 2023 levels but still significantly lower than the large surplus positions they held in 2022. This means some sponsors may be required to make service cost contributions and, if underfunded, additional contributions to pay off the deficit.  Funding requirements are primarily driven by asset experience, as the liability remains relatively stable year to year since it is calculated based on a 25-year historical average discount rate.

With surplus cushions largely depleted, some plan sponsors may be concerned about the tension between a liability-driven investment strategy and a funding liability that has little to no sensitivity to market discount rates. We provided additional context behind this disconnect and some strategies to help manage it in our 2023 ROA guide. Anecdotally, of these strategies, we have heard interest in electing the PPA “full yield curve,” which is close to a market discount curve. This signals that plans are generally adapting their funding policies to fit their LDI strategies, versus abandoning LDI to fit the PPA pension stabilization framework. We think electing the PPA full yield curve is a potentially reasonable approach for aligning management of the funding liability with that of the GAAP or economic liability, but we urge sponsors to consult with their actuary and/or legal counsel to understand the full set of implications. We also suggest conducting scenario analysis to quantify funding requirements under market and interest-rate scenarios across different investment approaches (e.g., LDI versus shorter duration) and discount-rate elections.

More focus on intermediate credit, with key differences from long credit

Intermediate credit continues to be of interest, particularly among plans that are better funded, own more fixed income, and no longer need capital-efficient sources of duration and spread duration. Also, the flat yield and spread curves have given rise to a potentially attractive structural allocation opportunity in intermediate credit (read more on this topic here).

There are some differences between the intermediate (1 – 10-year maturities) and long-duration (10+ year maturities) segments of the investment-grade market that are worth noting. For example, the intermediate segment of the market is significantly larger and more liquid than the long end. In addition, intermediate indices have a much larger allocation to the financial sector than long indices. With this in mind, plans might want to establish benchmark-relative industry limits across intermediate and long-duration portfolios, as opposed to absolute limits. Absolute sector limits (e.g., limiting financial sector exposure to 35%) can be more restrictive in an intermediate portfolio given the concentrated nature of the market in certain industries, which can limit a manager’s ability to express active views on the attractiveness of different industries.

The different nature of intermediate credit and long credit may also add style diversification to the liability-hedging portfolio. For example, we observe that since intermediate credit has a spread duration of about four years, spread volatility tends to be less impactful to returns. This may allow an intermediate credit strategy to exhibit more of a pro-risk tilt in pursuit of an income advantage versus its benchmark. Long credit, on the other hand, tends to experience greater volatility with a spread duration of about 13 years, and so a strategy in this space may be better positioned to outperform by leaning more defensive, or underweight credit risk versus its benchmark, when spreads are tight.

Liability-hedging diversifiers

Liability-hedging diversifiers may be additive for plans moving closer to their end state. While these plans will still focus on preserving their liability-relative match and avoiding excessive funded-ratio volatility, they may also want to address new priorities, including downside mitigation and widening the investment-grade opportunity set. Along with intermediate credit, mentioned above, the tool kit here may include private placements, long-duration securitized assets, taxable municipal bonds, and global credit, among other asset classes and strategies. Read more in our paper, Liability-hedging diversifiers: What’s on your pension’s playlist? You can also find a 2024 outlook from our private placements team here.

Return-seeking diversifiers

Return-seeking diversifiers have been gaining attention, and we think they offer the potential to reduce funded-ratio volatility while retaining some upside to funded-ratio return (a topic we cover in our paper on return-seeking allocations). Examples include infrastructure, real estate, hedge funds, and return-seeking fixed income. While plans may look to implement some of these diversifiers in private markets, public implementation also may be worth consideration, especially after the “denominator effect” many experienced coming out of 2022 (further thoughts on illiquid allocations below). We would also note that while 2023 was challenging for several of these return-seeking diversifiers, this could represent an attractive opportunity to add to or initiate strategic allocations.

Defensive equities and the challenge of market concentration

We continue to think defensive equities should have a strategic role in return-seeking portfolios — like return-seeking diversifiers, they can potentially help reduce funded-ratio volatility. In particular, we think plans should consider a multi-factor or multi-manager approach (beyond minimum volatility strategies) to defensive equities, which may help balance upside/downside capture and evolve as factors evolve, including low-volatility, “cash compounder,” and income-oriented defensive factors. More tactically, valuations on many defensive factors are currently cheap relative to history.

A hot topic in 2023 was narrow market performance, with a small number of large-cap names driving results. Whether this normalizes in 2024 remains to be seen, but narrow markets have been a headwind for active managers generally and defensive factors specifically. There are a few potential levers for managing market narrowness, including extension strategies (e.g., 140/40 strategies) and completion sleeves. Read more on market concentration in Learning to love (or live with) a late-cycle environment by Head of Multi-Asset Strategy Adam Berger

Illiquid allocations

Sizing illiquid allocations continues to be top of mind. Larger plans tend to have allocations to private market investments, and the declines in public market valuations in 2022 led to rebalancing, benefit payment, and lump-sum headaches. Some plans have tapped the secondary markets to sell private equity stakes, but the “haircuts” required to do this are often unpalatable, while others have cut or eliminated future commitments. Even after the public markets improved in 2023, this remained a topic of discussion among plans and may be one reason some plans have been slower to derisk. Read our thoughts on sizing and structuring private allocations.

Thoughts on setting an optimal liability hedge ratio

We think plans considering a higher hedge ratio should weigh the potential benefits (generally, lower projected funded-ratio volatility) against the costs (liquidity risk and the cost of synthetic implementation). Mature plans with high capital allocations to the liability-hedging bucket may find a 100% hedge ratio attainable with no or little reliance on synthetics, in which case we generally favor maximizing the hedge ratio. Less mature plans or those earlier on their glidepath, on the other hand, may need to rely heavily on derivatives to achieve such a result, introducing liquidity risk in addition to the cost of maintaining unfunded duration. In this case, the plan might consider the marginal funded-ratio volatility reduction associated with incrementally extending duration, the range of potential funded-ratio volatility outcomes under scenario testing, and the results of liquidity stress tests that provide a holistic picture of the plan’s liquidity needs. Depending on the plan’s characteristics and risk-tolerance levels, this exercise may call for increasing the hedge ratio but not fully hedging (e.g., a 70% – 80% hedge-ratio target). More details on this framework and case studies can be found here.

Taking equity spread duration into account

It’s generally understood that a plan’s hedging allocation should hold less credit/more Treasuries when the plan still has a large return-seeking/equity allocation, given the historical and expected positive correlation between equities and credit excess returns, and more credit as it approaches its end-state, when the return-seeking allocation is typically smaller. But how can plans set their specific breakdown allocation between credit and Treasuries along their glidepath?

We think the focus, when possible, should be on solving for the hedging blend that generates the lowest funded-ratio volatility or the most attractive expected risk-adjusted return (in funded-ratio space), depending on the objectives. This allows a plan to consider the composition and duration of the Treasury portfolio as part of the optimization process — specifically, the expected risk and return tradeoff between earning a credit spread and maximizing duration. A potentially simpler approach, if an optimization tool is not handy, is to assign a credit spread duration to equities and factor this into the credit hedge ratio. Based on our research and historical analysis, 5.5 years of credit spread duration may be a good rule of thumb for developed market equities, although we note the observed range has varied from about four to seven years. For plans setting a credit hedge ratio, we think a duration times spread (DTS) metric better captures credit risk and we typically assign a high-yield spread to equities. We plan to share more research on this topic later this year.

The implications of IBM’s novel use of pension surplus

Recently, IBM announced it will add a new cash-balance-type benefit earned within its overfunded and previously frozen DB plan in lieu of its employer 401(k) matching contribution. Could we be seeing a reversal in the decades-long transition from DB to DC plans? Time will tell, but we see a number of reasons that opening a cash-balance DB plan could be appealing to plan sponsors and participants. For example, because a cash-balance plan’s liability resembles a savings account, many cash-balance designs have only a nominal interest-rate duration and do not carry nearly the same amount of interest-rate volatility as a traditional annuity-based liability.

Another point that may be less appreciated is that a cash-balance plan, being a DB plan, must offer an annuity form of payment — this is a way to provide retiree income at group rates, potentially helping to address challenges with delivering income in a DC plan. For participants that do annuitize, the liability becomes a traditional DB liability that the company will need to manage. Retiree liabilities, however, typically have manageable durations (10 years is a good rule of thumb) that can be hedged via a liability-hedging strategy or other risk-management techniques (e.g., annuitization with an insurer).

We’ve noticed a few plans in strong overfunded positions starting to discuss what can be done with surplus in creative ways, and IBM’s move introduces an option that might have beneficial effects on both participants’ benefit security and the sponsor’s cash flow. That said, we see potential reasons for all plans — regardless of funded status — to consider the benefits of a cash-balance DB benefit (read our paper on cash-balance plans).

¹Based on estimated changes in yields and asset returns since reported funded ratios and discount rates at year-end 2022. Year-end data based on year-end 10-K filings of Russell 3000 companies in each given year with a December fiscal year end. 2023 estimate based on funded-ratio and discount rates estimated by Wellington Management based on change in high-quality corporate bond yields (Bloomberg US Long Credit Aa) since 31 December 2022 and performance of equities (MSCI World), bonds (blend of Bloomberg US Long Government/Credit and Bloomberg US Aggregate), other investments (blend of HFRI Fund Weighted Composite Index, MSCI December All Country World, and Russell 2000), and real estate (NCREIF Property Index). Actual results may differ significantly from estimates. Results presented at the aggregate Russell 3000 Index level. Sources: FactSet, Wellington Management. | ²Sources: FactSet, Wellington Management. Based on year-end 10-K filings of companies in the Russell 3000 Index in each given year. For illustrative purposes only.

Not actuarial or legal advice. Refer to actuary and counsel for advice specific to your plan.