No two defined benefit pension plans are the same. Different plans will see changes in their funded status based on their specific liability characteristics, the assets that make up their investment portfolio and other factors such as contributions, expenses, etc. This update covers Q2 2022 performance of asset values, pension discount rates, and the funded status implications of these movements for plans in various financial positions based on some typical investment portfolios.
Asset class returns for Q2 2022: From bad to worse
As you’re well-aware, in the second quarter we experienced one of the worst market downturns in decades. We thought Q1 was bad, but Q2 was much worse. It was clearly a risk-off environment. There was nowhere to hide. Equities, bonds, and commodities all lost money. Equity markets in particular suffered the most.
The culprit for this massive sell-off was the combination of a spike in inflation and rising interest rates. And these are phenomenon occurring globally. When the Federal Reserve started aggressively raising rates to combat inflation, equity markets had to reprice growth expectations. There was considerable talk about a recession and possibly stagflation. But it’s important to note that actual corporate earnings really haven’t started falling yet. All of the market action has been a resetting of expectations.
Because equities fell more than bonds this quarter (as opposed to Q1), plans with higher allocations to equities had a greater likelihood of experiencing a decline in funded status than plans with bigger fixed income allocations.
Q2 2022 – Volatility increases, heightened uncertainty in markets
Another notable development in markets has been the ramp up in volatility, which has increased this year from last in just about every market. What’s most concerning is that the volatility of fixed income has nearly doubled. Clearly, there’s uncertainty about rates and inflation. We’d like to see that moderate. For most equity markets, volatility is heightened but not dramatically. It’s curious that Emerging Markets equities look bond-like in their volatility.
We expected markets would be more volatile in 2022, but the magnitude of the increase has been surprising. The key question is how long this continues.
Over the first six weeks of the second half of this year, markets have recovered and regained some ground. There’s been some positive data supported the notion that inflation may be peaking: commodity prices, a slowdown in housing, and recent declines in gas prices all support that viewpoint. Combined with the resilience of the job market and corporate earnings, this may be leading investors to say, okay, this is going to slow and maybe even stop the Fed from further rate hikes. We should be fine.
Rebound: Head fake or new rally?
If this seems like a fast rebound, recall that in 2020, the market cratered in March, but then took off again in April. We ended the year in positive territory. Q1 of 2020 was worse than last quarter for equities. There’s an argument to be made that markets react faster in processing news these days.
On the other hand, could this be a head fake? If you look at bear market rallies historically, the average gain is a healthy 23%. So, it’s not unreasonable to be concerned that there’s another leg down or that we may be in for a sideways market for some time: from the end of the bull market in 1999 until 2009, the market was effectively flat.
We think that the answer to the question of “head fake or new rally” will be driven in large part by the Fed, inflation and corporate earnings.
The Fed: Anyone’s guess
It is difficult to predict where the Fed is headed. Even its voting members don’t have a great track record at predicting its future. At this point, it’s anyone’s guess.
Starting in December 2021, Federal Open Market Committee members expected the Fed Funds rate to hit 0.75 at the end of this year. In March, they updated that estimate to 1.75, and then in June, they estimated 3.25. Their projections for the next several years have increased as well. The only consensus is that by 2025, the Fed will have tamed inflation and moved back down to its long-run target of a 2.5% Fed Funds rate.
FOMC: Reacting to inflation
Clearly, the FOMC is reacting to inflation. Looking at five year forward expectations (i.e., inflation in 2027), market expectations peaked at 3.5% just before Federal Reserve Chairman Jerome Powell and the Fed brought out the big rate hikes. Since then, the market is signaling it believes that inflation will be brought under control (roughly 2.5%). While 2.5% inflation is a bit higher than the Fed’s target, but it’s a long way from 9.0%.
Looking ahead: Knowns and unknowns
In addition to the Fed and inflation, we’re watching a number of situations for guidance.
As if the human suffering weren’t enough, the war in Ukraine is clearly influencing inflation and growth prospects globally. Energy prices in Europe are threatening dire consequences. We’re looking for any signs that there are cease-fire negotiations.
China is clearly slowing down. Even the Chinese government has acknowledged it. Surprisingly, their central bank just cut rates. Then there’s the matter of President Xi getting another term and the saber-rattling around Taiwan and we have a lot of uncertainty swirling around the second largest economy in the world.
Finally, we are watching corporate earnings, which have hung in thus far. There will be mid-term elections this year, which could impact fiscal stimulus and perhaps tax policy. And additionally, we’ve got to pay attention to Covid variants. Any of these issues could move markets and there’s likely an unknown that we’re not contemplating.
Where to focus for the rest of 2022
In light of expected further volatility resulting from inflation, volatile growth, and potential Fed overshooting, we advise sponsors to stick to their strategic investment plan. Maintain a diversified long-term investment strategy and rebalance to target allocations when things get out of line.
Take what the market gives you, and de-risk as funded status improves by increasing the allocation to long term fixed income. For underfunded plans, have an investment strategy for the September deadline for contributions.
The sizeable increase in yields for 2022 represents an opportune time to reduce a short interest rate duration position versus liabilities, while valuations in credit look compelling. Cash balance plans could have changing liability profiles as crediting rates may be above the floor, so it is important to analyze updated cashflows.
It’s critical to be sure that your plan is well-positioned to handle volatility that 2022 could bring—the path forward from here will be bumpy.
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