Time to Hedge? Corporate Pensions Urged to Lock In Recent Gains

US corporate pension plans should consider adjusting their hedging positions as the Federal Reserve’s rate hiking cycle nears an end, according to Russell Investments.

Rising interest rates have contributed to significant improvements in funding ratios for private sector defined benefit (DB) pension plans, Russell’s latest Prudent Pension Funding Report said.

The Fed has increased its main interest rate from a historic low of 0.25% to a 22-year high of 5.5% in a series of increases since early 2022. This has led to the vast majority of DB plans (97%) now able to reach fully funded status within less than 10 years.

Three in five (62%) of plans could be funded in less than a decade with a sponsor contribution of 1% of cashflow from operations, the report stated. An additional third (35%) could be fully funded in the same timeframe on contributions of 3-5%.

Michael Hall, managing director for Americas institutional at Russell Investments, said: “Whether it’s through a small increase in contributions or a small increase in returns, full funding truly is attainable for most corporations in just a few years’ time.”

However, Russell’s report also emphasized that the link to interest rates could lead to a reversal in fortunes when the Federal Reserve stops raising rates. If a recession hits in 2024, the Fed might be forced to cut rates, leaving unhedged DB plans open to falling funding ratios.

“To lessen the risk of a potential decline in interest rates, now could also be the appropriate time for plan sponsors to consider elevating their hedge ratios,” the report stated.

Crisis or no crisis?

At the other end of the scale, Russell Investments found that a minority of plans — 10 out of the 500 plans in the study — would require a contribution rate of 20% or more to reach fully funded status in a decade.

Hall emphasized that this minority has historically driven a false narrative, creating the misconception that the majority of corporate pension plans are in crisis. The report provides a decade-long perspective, highlighting that in 2012, 78% of plans required more than 10 years to achieve full funding at a 5% contribution rate. In 2023, this number has dropped to just 2%.

The report also indicates a decline in the percentage of companies facing challenging situations, decreasing from 14% in 2022 to 4%. Furthermore, the gap between pensions in healthy funding situations and those facing challenges has significantly narrowed since the previous year's report.

For companies categorized as “healthy”, a slight increase in assets could substantially reduce the time required to achieve full funding. Similarly, companies in the "challenging" category would see notable improvements with prudent contribution rates and investment policies.

Hall also attributed the year-over-year improvement to the sharp rise in the Federal Reserve funds rate. However, he cautioned that a significant rate cut in 2024 could potentially reverse this trend. Consequently, he advised considering short-term contribution increases to ensure greater stability amid fluctuating economic conditions.

An improving picture

A similar study by Wilshire Associates also painted a picture of improving funding for pension plans. The aggregate funded ratio for US corporate plans increased by an estimated 0.3 percentage points during November, the consultancy group reported, ending the month at 105.1%.

The improvement was “mostly” due to aggregate assets increasing by more during the month than aggregate liabilities — 7.8% to 7.4%, respectively.

Ned McGuire, managing director at Wilshere, said the increase in liabilities was the highest monthly rise since December 2012 but was offset by exceptionally strong asset class performance, particularly from core fixed income.

Over the course of 2023 to the end of November, the aggregate funded ratio has increased by 6.4%, and by 5.8% over 12 months.