Rising interest rates put corporate pension plans on end-game path

U.S. corporate pension plans are on average fully funded for the first time in 15 years, and plan executives are now in the unfamiliar position of being able to achieve the end state of their plans.

The publicly traded U.S. companies with the 100 largest defined benefit plans can now boast an average funding ratio of 100.2% as of Dec. 31, according to Pensions & Investments' analysis of the latest 10-K filings.

It is the first time the annual analysis has shown an average ratio of more than 100% in 15 years. The average ratio as of Dec. 31, 2007, was 108.6%.

The latest numbers represent an improvement over the average funding ratio of 96.9% calculated at the end of 2021.

That improvement came despite a dreadful investment return environment that saw the Russell 3000 index and Bloomberg U.S. Aggregate Bond index return -19.2% and -13%, respectively, for the year.

The result of that down year of investment returns was that the top 100 plans accumulated $245.7 billion in investment losses (with an average return of -19.1%) during 2022, which contributed to total assets falling 26% to $1.076 trillion as of Dec. 31 from $1.463 trillion a year before.

Despite that loss of assets, however, funding ratios improved due to an extraordinary environment of rising interest rates.

As of Dec. 31, the average discount rate among measured plans was 5.25%, a full 237 basis points above the prior year's average of 2.88%. That dramatic rise in discount rates came primarily as a result of the Federal Reserve's aggressive fight against inflation, which reached its end point in the calendar year on Dec. 14 when it raised the federal funds rate to a range of 4.25% to 4.5%.

The end result is that total liabilities among the 100 plans measured by P&I dropped 29% to $1.075 trillion as of Dec. 31 from $1.51 trillion a year earlier.

While not all plans achieved 100% funding the past year, 50 of the top 100 plans have achieved that status, and perhaps even more remarkably, 31 of the top 100 plans were funded above 110%.

"Now comes the time where we tell our clients: 'You've reached this point. You've planned for this,'" said Justin Owens, Seattle-based director of investment strategy at Russell Investments LLC. "Now, job one is to maintain your funded position, and there is a way to do that with asset allocation, particularly if you're a frozen plan or a mature closed plan. You can position your portfolio in such a way that the probability of the plan becoming underfunded again is very low."

There is considerable incentive for not letting a plan get below a funding ratio of 100% again, Mr. Owens said. The Pension Benefit Guaranty Corp. charges both fixed and variable premiums to corporate DB plans, and the variable rates are determined by the funded status of a plan.

The current variable rate is $52 per $1,000 of underfunding, compared with only $9 per $1,000 of underfunding 10 years ago.

Given that incentive, now is the time for plan executives to ask themselves what their end states are, Mr. Owens said.

"It's never been more important to understand what you're trying to do," Mr. Owens said. "Are you trying to maintain it in a hibernation state for as long as it makes sense, or are you looking to terminate the plan?"

Mr. Owens added that not as many plans talk to him about plan termination as they did five or six years ago, perhaps feeling more comfort around taking those steps to reduce risk now that they're fully funded.

"You can fully hedge your interest rate risk, and you can do a lump sum cashout or a small annuity purchase and get your plan to a pretty manageable and sustainable state," Mr. Owens said.

He noted some plans might find it to be more of a headache to go through the termination process than to maintain their plans now that they have no contribution requirements and don't have to pay PBGC variable premiums.

Matt McDaniel, Philadelphia-based U.S. pension strategy and solutions leader at Mercer LLC, said in a phone interview that he sees most corporate plan sponsors eager to get out of the pension business.

"If you have a frozen plan and you're getting to 100% funded, or over 100% funded, there's not a lot of economic incentive to keep that plan running indefinitely," Mr. McDaniel said.

He did note, however, that if a plan has derisked adequately, and is now at nearly 100% fixed income and in hibernation mode, "it does take some of the urgency out of the plan termination question."

He said plan executives are more likely mulling over the timing of when to terminate their plans, rather than whether to terminate them at all.

"There's a significant accounting impact. What's the right time to take that settlement charge and take those accounting charges?" Mr. McDaniel said sponsors are asking. When a plan is terminated, the loss of pension obligations outside of the plan can typically cause a significant accounting charge on a company's balance sheets.

Michael A. Moran, New York-based senior pension strategist for Goldman Sachs Asset Management, said in a phone interview that many plans over the past few years have expressed the desire for some kind of pension risk transfer transaction, whether that was a full termination or liftout of a select population of retirees and beneficiaries.

However, in past years, companies would have had to make a sizable contribution to their plans, Mr. Moran said. Pension risk transfer transactions require full funding, and preferably a surplus so plans can use additional assets to pay premiums to insurance companies.

"Many of them can take more actions on the pension risk transfer side if they so desire, and as we saw last year was a record year for annuity sales," Mr. Moran said.

According to research firm LIMRA, U.S. corporate pension plan buyout sales totaled a new all-time high of $48.3 billion in 2022.

The new all-time high for U.S. pension buyout sales toppled the previous record of $36 billion set in 2012 and was up 42% from the 2021 volume total of $34.2 billion. Corporations have also benefited from lower premiums charged by insurance companies to transfer their liabilities. According to Milliman, the estimated average premium among the most competitive rates was 99.3% as of March 31.

As a result, the momentum shows no signs of abating in 2023. On May 1, Dallas-based AT&T Inc. announced the third-largest U.S. buyout transaction in history via its plan to purchase group annuity contracts from two Athene Holding subsidiaries to transfer $8.1 billion in pension liabilities.

For 2022, a full third of the record-setting volume came from a single transaction. In September, International Business Machines Corp., Armonk, N.Y., purchased group annuity contracts from Prudential Insurance Co. of America and Metropolitan Life Insurance Co. to transfer a total of $16 billion in U.S. defined benefit plan liabilities. It was the second-largest such transaction in U.S. history.

Between the buyout, benefit payments and negative investment returns, the company ended the year with DB assets totaling $25.1 billion, cutting assets more than half from $51.85 billion a year earlier. Liabilities fell even further, to $21.49 billion from $48.18 billion a year earlier. After all was said and done, IBM's funding ratio improved to 116.8% from 107.6%.

That transaction reflected the latest step in a 15-year journey for IBM, which froze its defined benefit cash balance plan to future benefit accruals as of Dec. 31, 2007.

While IBM officials never provided comment on the reasons for freezing the plan, when the company announced its intention in January 2006 to do so, it was far from alone in the corporate landscape.

Funding problems were vexing companies around the U.S. at the beginning of 2006.

GSAM's Mr. Moran said: "If you go back to the beginning of the century, and you think about coming off the bull market in equities in the 1990s, many corporate plans were massively overfunded. The tech bubble bursts, and many of them go from being overfunded to underfunded. Unfortunately, in some cases an underfunded pension plan contributed to the bankruptcy of certain organizations."

That led to a funding crisis for the PBGC's single-employer plan that threatened its financial stability. The agency created by ERISA was reeling from nine of the 10 largest overall pension plan claims taking place in just the previous five years.

Talk of reform to feature more stringent funding requirements in order to give the PBGC some relief had begun as early as 2003, and some experts warned almost immediately that corporate DB plans would continue to decline if more requirements were added.

Mr. Moran, in a November 2003 paper he co-authored with William C. Dudley, Goldman Sachs' then-chief U.S. economist, said "the proposed changes would exacerbate the decline in the defined benefit pension system. This is unfortunate because the continued shift to defined contribution plans significantly increases the burden on households in their retirement planning. Under a defined benefit plan framework, corporations, backstopped by the PBGC — funded by premium income from plan sponsors — typically guarantee a fixed monthly retirement benefit. This shifts the investment risk from the individual to the plan sponsor. It also reduces the risk of an individual outliving his or her financial assets under the defined contribution plan framework."

Messrs. Moran and Dudley's prediction came true. The Pension Protection Act of 2006, which was the most sweeping pension-related legislation since ERISA, featured new funding requirements for corporate pension plans and the Financial Accounting Standard Board's FAS 158 rule, also in 2006, placed pension funding on companies' balance sheets.

Funding levels certainly improved by the end of 2007, although that was more due to a positive return environment because the impact of the reforms were yet to be widely felt.

The impact of the global financial crisis the next year was reflected in the average ratio plummeting to 79.1% as of Dec. 31, 2008, an almost unbelievable drop of nearly 30 percentage points in just 12 months.

The PBGC would need funding relief again in a few short years, and in 2012, President Barack Obama signed the Moving Ahead for Progress in the 21st Century Act. The Map-21 law established hikes to both the agency's variable rate (seen above) as well as its fixed rate, which is measured per participant in a corporate DB plan. That fixed rate was $35 in 2012, only $4 above its rate in 2007. The fixed rate has now grown to $96 in 2023.

While rising variable rates gave companies added incentive to fully fund their plans, rising fixed rates also gave them the incentive to reduce the number of participants in their plans, leading to more pension plan buyouts, often targeted toward participants with lower monthly benefits.

Finally, in December 2017, President Donald Trump signed the Tax Cuts and Jobs Act, which reduced the corporate tax rate to 21% from 35%. Corporations had until Sept. 15, 2018, to deduct those contributions at the higher 2017 rate. The result was that S&P 500 companies with DB plans contributed a total of $26.1 billion to their global pension funds in 2018, including 10 that contributed nearly $1 billion or more.

Many of those large contributions were meant to fulfill minimum funding requirements for multiple years, and those accelerated contributions, followed by excellent investment returns in 2021 and rising rates leading to falling liabilities in 2022, led to half of the top 100 plans reaching full funding.

Even the plans that have not reached 100% have shown remarkable improvement, and there is no better example of that than the airline industry, which suffered funding woes for years following the events of Sept. 11, 2001, that led to depressed air travel, falling profits and economic uncertainties.

Delta Air Lines Inc., Atlanta, had the worst funding ratio among all U.S. corporations just 10 years ago. As of Dec. 31, 2012, Delta had $8.2 billion in assets and $21.49 billion in projected benefit obligations, to chalk up a miserable ratio of 38.1%.

That number came even after the PPA provided specific funding relief for airlines through the end of 2017. However, after years of outsized contributions, the MAP-21 bill, strong investment returns and a rising rate environment, Delta's funding ratio as of Dec. 31 was 99.4%.