Higher Rates May Not Equal Higher Corporate Pension Returns

The U.S.-listed companies with the largest corporate defined benefit liabilities are a bellwether for the corporate pension industry, and data from recently released annual reports offer a fascinating look at developing trends.

It turns out that funded ratios for the largest 21 corporate DB plans declined in 2023, with an average drop of 1.4%, despite relatively strong equity performance (these sponsors also have large allocations to fixed income). The gains on the assets were insufficient to overcome the losses in the liabilities due in part to a ~25 basis points fall in discount rates and higher interest cost relative to recent history. Going forward, plan sponsors should consider the appropriateness of their asset allocation in the context of higher liability return needs.

Also, as widely reported, one of the largest corporate DB sponsors – IBM – made a significant shift from offering matching contributions in its defined contribution plan to offering DB benefits in its previously-frozen, overfunded U.S. DB plan. We at Russell Investments are advocates for a shared DB / DC retirement benefits model, but we also think the program designed by IBM could be improved upon by reducing (rather than eliminating) the DC match, allowing for interest credits in the DB plan tied to portfolio performance and the ability to bifurcate the DB benefit into a lump sum and annuity piece.

Justin Owens

I would like to focus here on a new finding in considering 19 years’ worth of historical data we have collected for this group. Not once in that time has the average expected return on assets assumption, EROA, increased year over year. Sponsors that have only decreased their EROA assumptions to this point ought to take notice and evaluate the appropriateness of their current assumptions.

We can attribute the historical downward trajectory in EROA to two trends.

• First, these plan sponsors have made significant shifts toward liability-hedging fixed income over time, an asset class that generates lower expected returns than most other assets. In 2011, the average portfolio allocation to fixed income for this group was 37%. It has now increased to 54%. This is partly due to the adoption of de-risking glide paths, which naturally lead to more fixed income as funded status improves. Funded status last year reached its highest level since before the Global Financial Crisis in 2008, and sponsors have made considerable progress on their glide paths.
• Second, until 2022, the fixed income yield and expected return had generally declined. The combination of low yields and the potential for rising rates (which have a negative impact on fixed income returns) dampened fixed income return expectations, at least in the medium term. This impact, along with the higher allocation to fixed income, pushed EROA assumptions down.

It is hard to believe that just 11 years ago, the average EROA assumption for this group was 7.75%. In 2022, that number had fallen to 6.12%, dipping lower each year. Now, having reviewed the latest filings, we see that most of these companies increased their EROA assumption for 2023 pension expense purposes, with the overall average increasing to 6.70%, as shown here.

Average EROA assumptions

9%

8%

7.75%

7.73%

7.61%

7.38%

7.32%

7.03%

6.87%

7%

6.70%

6.57%

6.28%

6%

6.12%

5%

2014

2013

2015

2016

2017

2018

2019

2020

2021

2022

2023

9%

8%

7.75%

7.73%

7.61%

7.38%

7.32%

7.03%

6.87%

7%

6.70%

6.57%

6%

6.28%

6.12%

5%

2014

2013

2015

2016

2017

2018

2019

2020

2021

2022

2023

9%

8%

7.75%

7.61%

7.32%

7.73%

7.38%

6.87%

7%

6.70%

6.57%

7.03%

6.28%

6%

6.12%

5%

2014

2013

2015

2016

2017

2018

2019

2020

2021

2022

2023

9%

8%

7.73%

7.61%

7.32%

7.75%

7.38%

6.87%

7%

6.70%

7.03%

6.57%

6.28%

6%

6.12%

5%

2013

2015

2017

2019

2021

2023

Source: Russell Investments

This rise in return expectations is primarily due to the rise in fixed income yields, though asset allocation changes may also play a part as well. The material increase in rates in 2022 and its impact on EROA assumptions leads to a few important takeaways for plan sponsors:

• First, EROA assumption in the U.S. is used in pension expense calculations (i.e., the impact of the pension plan on the corporate income statement). Higher return assumptions lower pension expense (or increase pension income) in isolation, but there are other moving pieces related to higher rates in this calculation. Pension expense calculations are complex and important to many plan sponsors, but changing the EROA assumption does not directly impact the economics of the pension plan.
• Second, return assumptions have increased, but perhaps liability return needs have increased more. Liabilities grow with interest, so higher interest rates lead to higher asset returns needed to offset liability return requirements. This increase can at least partially be covered by higher expected returns in fixed income.
• Third, equity returns may not be as attractive relative to fixed income returns as they used to be. While expected fixed income returns have improved in capital market assumptions over the last year or so, equity market returns may not have changed as much as fixed income, depending on the method used.

This could enliven the discussion on potentially “re-risking” the portfolio (i.e., increasing equity-like exposure) to try to generate additional return to cover liability growth and some excess, depending on long-term objectives and current funded levels. That said, we at Russell Investments generally would not advise scaling back on hedging interest rate risk.

Another recent example for this group is the lawsuits involving AT&T and Lockheed Martin related to their selection of annuity purchase providers in pension risk transfer transactions. We expect more consideration and scrutiny on pension risk transfer transactions going forward. While these types of strategies are inevitable for many plans, the timing, pricing and administrative lift of this task may not always make sense. Sponsors should also take steps to ensure they have checked all the appropriate fiduciary boxes during this process.   

Since trends in the U.S. corporate DB industry tend to begin with these companies, it is beneficial to keep an eye on developments involving them. Following the largest sponsors will give us more insight into what may be coming for everyone else to help to fulfill their fiduciary responsibilities.

Justin Owens is senior director, co-head of Strategic Asset Allocation at Russell Investments.