Dark clouds loom for 2022 asset returns: S&P 500 falling into -20% bear market territory in June, international equities have fallen -19.6% partially thanks to a strengthening dollar. Long Gov/Credit bond returns are also down more than 20% through August as yields have increased in short- and long-dated maturities by 316bps and 176bps, respectively. (Chart 1)
Chart 1: Change in Buck AAA/AA Corporate Bond Spot rates from 12/31/2021 to 8/31/2022
The silver lining for defined benefit plans is that the funded status increased in 2022 for most plans with hedge ratios less than 100%, despite the losses on the asset side.
2022 funded ratio improvement examples
Let’s consider a hypothetical plan that is 100% funded at 12/31/2021 with a liability duration of 16 years, a strategic asset allocation of 40% Long Gov/Credit (i.e. a hedge ratio of 38.5%), and a hypothetical return-seeking drawdown of 20%. (Table 1)
Table 1: Funded ratio improvement for a plan invested with an allocation of 40% Long Gov/Credit
*This simple example ignores convexity
This example demonstrates how beneficial the rise in rates in 2022 has been for the funded status of many defined benefit plans.
As demonstrated by another hypothetical plan with a traditional 60% Diversified Return-Seeking/40% Aggregate Bond allocation, the funded status improved from 100% to 107% as assets outperformed liabilities in 2022 despite drawdowns in equities and bonds. (Chart 2)
Chart 2: Outperformance of assets over liabilities and funded ratio improvement for a plan invested with an allocation of 60% Diversified Return-Seeking/40% Aggregate Bonds
The higher yield on bonds in 2022 has created an attractive time to lock in funded status gains. Due to Federal Open Market Committee actions responding to COVID, short-term treasuries had an expected yield close to 0% before 2022, which forced investors to allocate to stocks with higher expected returns. Now with 1-year bond Treasury yields above 4% (as of 9/19/2022) bonds now yield more than the dividends on most stocks.
The silver lining
Given the magnitude of changes in capital markets during 2022 of yields, equity valuations, and funded status, now is an ideal time to review the plan’s strategic asset allocation with an asset liability study. Changes in both the allocation to fixed income and the duration of the fixed income portfolio should be considered to reduce funded status volatility and to lock in the 2022 funded status gain. In addition, plan objectives should be reviewed in the context of the opportunities presented by the 2022 silver lining, which currently provides opportunities for hibernation, pension-risk transfer, or even termination.
An increase in funded status is a favorable outcome despite market volatility in 2022. Volatile conditions are expected to persist with many economic indicators pointing to the US already in a recession. Given it’s impossible to time the market perfectly, we believe when the market gives you a gift, you should take it – now is the time to prepare for any potential future storms.
The investment products and strategies in this document are for presentation purposes only. Any dissemination, distribution, or duplication of this document or any of its contents without prior written consent from Buck Global, LLC is strictly prohibited. This document does not consider your or your plans’ specific investment needs. This document is not a solicitation to buy or sell any investment, nor to participate in any type of trading or investment strategy. The purpose of this document is to illustrate hypothetical scenarios with respect to funding and managing pension plans and other guaranteed benefits. Before making any investment decision, you should seek the guidance of a qualified financial or investment advisor such as Buck.
All information that is obtained from external sources cannot be guaranteed but is provided by those who have been proven to be credible, reliable, and recognizable.
Buck Global LLC is registered in the United States as an investment advisor with the SEC. Registration does not imply a certain level or skill or training. Further information about buck may be found at: https://adviserinfo.sec.gov/