The 100 largest U.S. corporate defined benefit plans are now estimated to be fully funded, on average, at 101.3%. The prior peak funding level was in 2007 with an average funding ratio of 108.6%. Even with plans being closed, frozen and after numerous pension risk transfers, assets stand at an all-time high of $1.413 trillion. Only four plan sponsors are estimated to have a funding ratio below 80%. Two of the poorly funded plans are energy companies and two are passenger airlines. Seventy-one plans are estimated to be 95% or more funded. Exceptional funding levels can be attributed to substantial and consistent contributions, and excellent risk management through the use of liability-driven investing strategies.
Improved funding ratios were achieved in spite a very tough interest-rate environment that has existed since 2005. Average discount rates peaked in 2008 at 6.4% and have steadily fallen. With a second round of quantitative easing, to counter the COVID-19 pandemic economic turmoil, discount rates fell to a shockingly low 2.6%, on average, in 2020. A sharp reversal of rates this year has contributed 5.6 percentage points to corporate funding levels, according to estimates from Legal & General Investment Management America.
Plans in aggregate have taken steps to reduce investment volatility. Public equities have fallen to 32% of plan assets from 62% in 2005. Alternatives play an important role, but are down from a peak level of 21.8% in 2016. In 2020, private equity received about half of alternative allocations, while real estate and hedge funds received about a quarter each.
As plan sponsors have adopted a liability-driven investing strategy, the average fixed-income allocation has soared to 48% in 2020 from 27.5% in 2005. That represents about $680 billion in fixed-income assets, up from about $280 billion in 2005. Thirty-eight plan sponsors had more than 50% in fixed income, up from 12 in 2010. In 2020, only eight plan sponsors had less than 25% of assets in fixed income.
The median assumed rate of return, or ARR, fell to 6.75% from 8.5% in 2005. The difference between the 75th and 25th percentile ARR has expanded significantly to 110 basis points from 45 basis points in 2005, as some plans still have a risk-based portfolio, while the majority have a fixed-income-heavy portfolio.
The spread between the ARR and discount rate jumped to 398 basis points in 2020 compared to an average of 293 basis points since 2005. Assuming equities, fixed income, alternatives and cash return 6.5%, 3%, 7% and 1.5%, respectively, plans would earn only 4.75%. If interest rates stay at current levels, more cuts in the ARR are to come.
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