The Plus Side of Rising Interest Rates: Lower Pension Liabilities

Interest rates are on an upward march, as they hustle to keep up with surging inflation. This has unsettled bond prices, which move in the opposite direction from yields, but the climbing rates also offer a boon to pension programs: Plan liabilities shrink.

Higher interest rates, courtesy of the Federal Reserve, mean plans need to set aside less to fully fund pension obligations because the present value of future payments shrinks. At aerospace giant Lockheed Martin, for instance, each rate increase of a quarter percentage point reduces the defined benefit plan’s liabilities by $1.5 billion. The company’s accrued pension liabilities stood at $8.3 billion at year-end 2021.

The U.S. rate-rising trend should help plans’ quests for better funded status, which had been improving thanks to, among other things, a rising stock market. Of course, equities have slipped in 2022. “Funding status is a combination of interest rates and asset values, so there have been only moderate gains in funding status this year,” says Paul Colonna, president and CIO of Lockheed Martin Investment Management Company.

Meanwhile, for corporate plans that have embarked on de-risking campaigns, higher rates may also induce changes in allocation strategies, says Sweta Vaidya, head of solution design at Insight Investment.

Rate Repercussions

After many years of easy money, the Fed’s push for loftier rates—unwisely delayed, critics say, in light of relentless inflation—appears to be locked in. “Only now are we retracing interest rates” to higher levels, remarks Sean Kurian, head of institutional solutions at Conning.

One uncertainty surrounding higher rates is the path of long-term instruments, as the market determines their yields much more than does the Fed. The 10-year Treasury is the world’s premier refuge investment in times of global stress, which the Ukraine war and the pandemic are fueling.

“When the Fed is in a hiking cycle, like it is now, front-end rates will necessarily rise,” says David Eichhorn, CEO of NISA Investment Advisors. “The impact on the back end, which is what pensions care about, is more ambiguous.”

Another part of the financial equation is higher rates’ malign impact on bond prices. The Bloomberg US Agg, tracking investment-grade taxable bonds, is down 8.5% this year, even worse than the 7.8% drop that the S&P 500 has suffered. And here we always thought that a drop in stocks was offset by a rising bond market.

Because the Federal Reserve’s well-telegraphed intentions have pushed up short-term Treasury rates (which the central bank directly influences) faster than longer rates, investors have gotten a gift. With the yield curve much flatter than before, “they can get similar yields with less risk,” says Insight’s Vaidya.

Indeed, as of Monday, the two-year Treasury now yields 2.46%, closer to the 10-year’s 2.85% than before. At year-end 2021, they had a much wider spread: the two-year was at 0.78% and the 10-year at 1.63%. Furthermore, the spread between Treasury bonds and corporate paper has tightened: 3.43 points, near an historic low (which occurred in early 2020 as the pandemic began).

The duration of the two-year is just 1.9 years, so a one percentage point increase in its yield means it will drop 1.9% in price. For the 10-year, though, the duration is higher, as it will be around much longer than the two-year and lots of things can happen, i.e., it’s riskier. The 10-year’s duration is 8.8 years, so a one-point rate boost drops its price 8.8%.

Regardless of such pain points, the brighter financial status of many plans nowadays—whether public or private—gives them flexibility and resilience. “We’re in a benign credit environment” with strong balance sheets and low defaults, says Jared Gross, head of institutional portfolio strategy at J.P. Morgan Asset Management. “They have a lot of cash.”

Numerous  pension plans have copious cash parked in money market funds. If crisis hits, they’ll be ready. “Investors like pension funds can easily afford to redeem money markets at a small discount to par to obtain liquidity if needed, as this is minimal compared to selling anything else in a crisis, at large losses,” says Matt Clark, CIO of the South Dakota Investment Council. As of the end of fiscal 2021, SDIC had 2% in money funds, or $369 million.

Corporate De-Risking Maneuvers

For corporate DB funds, higher rates have a special resonance because they affect liability-driven investments, which most often means de-risking—and thus moving to bonds from equities. Partly with the help of LDI, corporate funded status has climbed back to the healthy level it enjoyed before the 2008 financial crisis:

As of the end of 2021, it stood at 96%, up from 88% in 2020, according to Willis Towers Watson.

NISA’s Eichhorn expects rate rises won’t affect LDI in a major way, although more plans may opt for an LDI strategy. As funded status increases, interest would mount in LDI, he reasons. After all, with enhanced ability to meet obligations, a plan needs fewer risk assets to better its condition.

Different portfolios have different asset allocations, and higher rates may prompt some to shift strategies. In LDI parlance, the fixed-income portion is the “hedge,” as it typically mimics the interest rate sensitivity of the liability. Consider portfolios that are under-hedged on interest risk. When rates go up, their funded status likely would improve, with the shrinkage of pension plans’ liabilities outpacing the reduction in the fixed-income portfolio, says Insight’s Vaidya.

As the Fed continues to raise rates and the Treasury yield curve flattens, pension investors (and other types of investors) are responding by shortening duration positions, seeking to earn similar yields with less risk, says Vaidya. “This opens up opportunities in the middle of the yield curve, especially in credit markets: intermediate credit, structured credit, high-yield, etc.,” she adds.

What about plans with low allocations to fixed income, or low funded status? Odds are they will be under-hedged on interest rate risk relative to their liabilities, she says. As rates rise, they are likely to see funded status continue to improve since liabilities will shrink faster than the values of fixed-income investments.

Higher funded status should produce more risk reduction to protect gains, via bonds or derivative fixed-income instruments, according to Vaidya. Adding derivatives such as Treasury futures, interest rate swaps, and total return swaps can improve interest rate hedging with more capital efficiency—freeing up capital from fixed income to be redeployed into growth assets, notably equities and alternatives.

Then there’s a possible impact from higher rates on pension risk transfers, which are when a plan offloads its obligations to an insurer. A smaller liability means that insurers probably will charge plans less to take on their pension programs, Vaidya says. And more plans would be eligible for a PRT, as becoming fully funded would be easier. Insurers most often want a plan to be 100% funded or better.

Absent a recession, rates seem destined to ascend. And that situation, for now, has a lot to recommend it.

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