Bond Tantrum Has Big Silver Lining for Pensions

(Bloomberg Opinion) -- As is often the case with large market swings that evoke the specter of a “regime change,” it's only a matter of time before pension-fund behemoths enter the conversation to quiet the hysteria. It makes sense: Defined-benefit plans are tasked with seeing through intermittent noise and focusing on longer-term trends that will influence their ability to make promised payments to retirees.

In Australia, at least, large investors aren't buying the new narrative on resurgent inflation. “‘Markets Are Wrong': $2 Trillion of Pension Funds Skip Bond Rout,” Bloomberg News's Ruth Carson and Matthew Burgess wrote, based on interviews with five pension funds that help oversee parts of Australia's A$2.9 trillion ($2.3 trillion) in retirement assets. The price-growth question is framed in terms of its implications for more than $46 trillion of pension assets globally.

While substantial losses on fixed-income assets would certainly leave a mark, rising interest rates would most likely have an even greater positive effect on the liabilities side of pensions' balance sheets. In fact, if some projections are to be believed, the 100 largest U.S. corporate defined-benefit pension plans could reach a 100% funded ratio for the first time since the 2008 financial crisis. Defined-benefit fund managers should welcome this so-called tantrum with open arms.

As a reminder, defined-benefit pensions promise to pay retirees a set amount, typically derived from a formula that takes into account age, salary and length of employment. This creates a significant future liability. For accounting purposes, the plans use a discount rate to gauge the present value of the future obligations, with the resulting amount known as the projected benefit obligation, or PBO. The difference between the PBO and the market value of assets is a pension's surplus or deficit. 

Clearly, the discount rate plays a huge role in this calculation. Almost without fail over the past decade, the funded status of the 100 largest U.S. company pensions worsens when longer-term bond yields tumble and improves as interest rates rise, according to Milliman data. In the most recent example, the benchmark 10-year Treasury yield fell to 0.5% in early August, the lowest closing level ever. It follows, then, that the overall funded ratio of these 100 pensions touched a multiyear low at the end of July, when Milliman's discount rate was just 2.26%, almost 100 basis points lower than at the start of 2020. 

Further unwinding of the steep decline in U.S. yields could have near-immediate effects on these pensions. Milliman's “optimistic” forecast shows that if the discount rate increased by 55 basis points between the end of January and the end of the year and assets posted a 10.5% annual return, the plans would be fully funded within several months. In February alone, 10-year Treasury yields increased 34 basis points and as much as 54 basis points when measuring from the height of Thursday's extreme selloff. The discount rate doesn't quite move in parallel with U.S. yields, but directionally, interest rates are clearly moving along the optimistic path.

A move higher in longer-term bond yields without drawing forceful action from the Federal Reserve wasn't always a sure thing. As I wrote at the end of last year, when it was still unclear whether 10-year yields could breach 1%, it looked as if defined-benefit plans were on track for significant struggles. After all, real inflation-adjusted yields were negative across the U.S. yield curve, including -0.4% for 30-year bonds. Since then, 30-year real yields have turned positive (if only just), reaching as high as 0.3% briefly last week. That's something close to a regime change packed within two months, even if pension managers won't admit it.

The outlook is less rosy for state and local government pension plans, which have dug themselves into deeper holes than their corporate counterparts over the past two decades. A Moody's Investors Service report released last week concluded that the combination of low interest rates and lofty return targets have pushed these funds into riskier investments, with just 20% of their $4.8 trillion in total assets classified as “debt securities.” In an extreme example, the Arizona Public Safety Personnel Retirement System, which assumes 7.3% annual returns, targets just 5% in bonds and cash “while relying much more heavily on private equity for asset growth.”

At the public pension level, the impact of discount rates is profound. The Governmental Accounting Standards Board requires only “assumptions that are consistent with the standards of practice of the actuarial profession.” In practice, this means the discount rate is usually the long-term expected rate of return on investments. The New York State Teachers' Retirement System is 98% funded using the GASB funded ratio — but just 59% funded using Moody's market-based discount rate. The Florida Retirement System is 79% funded under GASB standards but just 48% in Moody's calculation. The New Jersey Teachers' Pension and Annuity Fund is in a tough spot by either measure: 27% funded per GASB, 19% per Moody's. Higher interest rates may narrow the gap between the two but will only go so far in solving the underlying problems.

Regardless, pensions are among the most obvious winners from higher long-term U.S. bond yields. The Fed desperately wants to generate average inflation of 2% so it can conduct monetary policy away from the zero lower bound, an uncomfortable place it has occupied for much of the post-2008 era. Fund managers, who have also felt trapped in a low-rate world, should welcome this possible structural shift, even if their natural inclination is to insist that deflationary forces are still prevalent.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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