Corporate pensions and the trillion dollar call

The liabilities of corporate pension plans are much more sensitive to changes in interest rates than their assets are. That mismatch may have cost more than a trillion dollars over the past four decades.

The biggest cause of variation in funded status

The single factor that—more than any other—has driven the ups and downs of U.S. corporate pension plans in recent years has been interest rates. Consider, for example, the changes since 2005 in aggregate funded status, as shown in corporate accounting statements, of 19 of the largest plan sponsors, a group we refer to as the $20 billion club.

Sources of gain/loss for the $20bn club: 2005-2016

2008 was a disastrous year, as markets fell all around the world. A net surplus of around $50 billion was wiped out and in its place arose an underfunded position that has persisted to this day. While 2008’s losses were investment losses (the grey bar), the primary driver of changes in funded status since then has been actuarial gain/loss (the light blue bars.) Actuarial gain/loss is almost entirely attributable to changes in interest rates.¹

This suggests that, while investment returns obviously matter for pension plans, interest rate changes matter even more.

Actuarial losses in 2012 and 2014, shown in the chart above, each totaled roughly $100bn. So that’s $200bn in losses for just 19 plan sponsors in just two years. Add in the other years shown above, add in the assets and liabilities of the hundreds of other U.S.–listed plan sponsors (whose plans, on average, probably have a larger mismatch between assets and liabilities than the $20bn club’s do), and extend back over the 25 years from the interest rate peak in 1981 to the start of our chart above²—and there’s a strong case to be made that the total losses arising from the interest rate mismatch since 1981 have most likely exceeded $1 trillion.

Give up now?

Most plan sponsors understand the scale of the bet on interest rates better today than in the past, but the decision of whether or not to stick with it is not simple. Even though the interest rate mismatch has been a losing position overall, there have been periods where it has been beneficial. The upside when that happens is large. The chart above, for example, shows that in a single good year (2013) roughly half of the total shortfall of assets below liabilities disappeared.

That’s one reason that the prospect of reducing exposure can be daunting: when interest rates do finally reverse their near–forty–year downward trend, nobody wants to look back and realize they bailed at the bottom.

This concern has slowed the reduction of the interest rate mismatch, but it has not stopped it altogether: a look at the investment strategy of the $20bn club shows that at least six of the 19 sponsors have shifted 10% or more of their portfolio into fixed income in the past seven years. IBM, for example, increased their fixed income allocation target by 14% in 2016.

The size of the interest rate mismatch remains the single biggest policy decision for a pension plan. It has been, literally, a trillion dollar call.