Rising rates benefit funding further in 2022

The first quarter of 2022 brought significant movement in two of the main components that impact the discount rate calculations for corporate defined benefit plans: nominal interest rates increased and credit spreads widened.

"The impact of that is discount rates for most corporate DB plans have probably gone up well over 125 basis points so far this year," said Michael Hall, a managing director at Russell Investments in Seattle. "And for a number of our clients, just this year, that number has gone up 150 basis points."

A 1% change in the discount rate can raise or lower plan liabilities as much as 10%, or more for less mature plans, Mr. Hall said, "So where they stand today is thankfully better funded than they were at the beginning of the year, and a lot better funded than they were at the beginning of last year."

U.S. corporate plan funding increased to an estimated 97.4% as of April 30, according to a report from Wilshire Advisors, up from 95.4% at the end of 2021. That improvement has come despite corporate plans returning a median -6.9% in the first quarter, according to data from Northern Trust Corp.

Mr. Hall said it's also important to note the dollar amount of projected liabilities, in addition to the funding ratio percentage, when discussing corporate defined benefit plans. As an example, Mr. Hall said about half of the Russell 1000 companies disclose defined benefit plan obligations, and the average dollar amount of unfunded liabilities among those companies was about $530 million in 2020. In 2021 disclosures, the average dollar amount dropped to about $200 million.

"Here's some simple math," Mr. Hall said, "$530 million turns into $200 million for about 500 companies. So $300 million, on average, times 500 companies comes out to about $170 billion less in unfunded liability for those 500 companies in the Russell 1000 that have pension disclosures."

Mr. Hall said looking at dollar amounts on the asset side of funded status is equally important. Reducing the equity portfolio while moving along a fixed-income glidepath could increase management fees as the equity investments grow smaller causing them to move into a higher fee structure as a result with less scale.

Market volatility can also impact the plan's assets, and factor-based low-volatility strategies can be useful in providing diversification while efficiently managing the plan's capital, he said, as well as ultralong Treasury bonds that offer efficiency in managing the volatility of the interest-rate component of the plan's liability.

In addition to low-volatility global equity beta strategies, Mr. Hall said non-dollar emerging markets debt, high-yield debt and private credit could also fill roles on the growth side of a policy portfolio. "Shorter-duration private credit may give you both diversification and more yield, and not get in the way of the time horizon that you're managing," he said.

Mr. Hall said some sponsors are also looking at longer-duration private credit, which can be used to match the time horizon of the plan's liabilities or could be used when transferring assets to an insurer as part of a risk transfer transaction, if that opportunity arises.

As a long-term investor, Paul Colonna, president and chief investment officer of the Lockheed Martin Investment Management Co., said private market co-investments can provide a productive income stream.

"I think our biggest inherent natural advantage is we have a long-term horizon. We're not trying to beat a quarter. We're not trying to beat a year or more. We're trying to execute a strategy that is five, 10, 15, 20 years out in the future," Mr. Colonna said.

Lockheed Martin looks for opportunities in co-investments beyond the traditional return profile, he said. As a strategic investor, he is looking for ways to share economics and reduce fees through the right partnership opportunities, Mr. Colonna said, and co-investments have been a better fit, in this sense, than the larger alternative funds.

"We're looking for more out of our strategic partners. And I think we're getting that, which is fantastic," he said. "About 25% of our activity last year was in co-investments, and so that's no-fee, no-carry. We've got our core set of partners. We believe in them and we're driving, hopefully, an additional value-add to the co-investment process with them," Mr. Colonna said.

Measured at net asset value, Lockheed Martin had $5.4 billion of plan assets in private equity partnership and co-investment funds as of Dec. 31, $3.06 billion in real estate partnerships, most of which are closed-end funds, and $556 million in hedge funds, according to the firm's 10-K filing.

Alternatives also have a role in Lockheed Martin's liability-driven investment goals, Mr. Colonna said. A traditional LDI portfolio buys duration-matched, investment-grade corporate debt, which has cash-flow limitations and doesn't offer broad diversification, he said, and investment-grade bond pricing hasn't been particularly attractive in recent years.

"We want diversified, really durable, high-quality, long-duration assets that fall outside of the corporate bond market. You can think of things like credit tenant leases, infrastructure debt, things that just don't have a typical home in a more traditional LDI strategy. And capturing some illiquidity premium for a really durable high-quality cash flow that's going to outperform a corporate bond over the next 10, 15 years is attractive to us. And we'll continue to diversify the LDI book in that manner," Mr. Colonna said. He declined to disclose the size of the LDI portfolio.

Illiquidity is sometimes cited as a drawback for private market commitments, Mr. Colonna said, but the defined benefit plan structure has room for more illiquid investments than many asset owners take advantage of. "Every plan is different," he said, "But you have to pace out your benefit payments, your liability streams, and all those things are measurable and you can account for variances and future possibilities."

Lockheed Martin Corp., Bethesda, Md., purchased group annuity contracts from Athene Holding Ltd. in August 2021, transferring about $4.9 billion in U.S. pension plan liabilities, after transferring $1.4 billion in U.S. plan obligations at the end of 2020. Pension liabilities fell 15.39% to $43.48 billion, as the plans' discount rate rose 38 basis points to 2.88%, and assets decreased 8.55% to $35.2 billion at the end of 2021.

The plans returned 11.1% in 2021 and the funded status improved 6.1 percentage points to 81%.

The DB plan has been frozen since January 2020. In addition to defined benefit assets, Lockheed Martin also sponsors approximately $50 billion in defined contribution plans.

Mr. Colonna said Lockheed Martin views the DC plans "as something that should incorporate some aspects of DB plans and alternative investing is one of them. But there are hurdles. Fees are one of them. Operationally, structurally, how do you price illiquid assets in a DC plan? How will the Department of Labor and other regulators that are out there view the fiduciary construct of alternatives in a DC plan? Litigation is, unfortunately, prevalent so you have to think about litigation. All these things go into our mission of trying to deliver alternatives but we'd like to do it. We think it's the right solution."