Corporate pension plans could become fully funded once the 10-year yield rises above this level
One of the most significant ways in which the 2007-09 recession altered the financial landscape was how the emergence of ultralow interest rates, intended to prop up the recovery, ravaged public and private pension plans, potentially throwing retirees into dire straits during their golden years.
But with interest rates resurgent after a period of dormancy, investor anxiety over rising borrowing costs may be overlooking the benefits of advancing bond yields for savers and retirees, helping to bridge the yawning funding gaps of their savings plans. Tom Lee of FundStrat Global Advisors said if the 10-year Treasury yield TMUBMUSD10Y, +0.22% exceeded 3.0%, the rising discount rate could boost the shares of corporations with underfunded pension funds.
“We believe investors will benefit by focusing on companies that benefit, or are positively leveraged to higher interest rates. A somewhat less intuitive example are those companies with deficits in their pension obligations,” said Lee.
If the 10-year yield rose as high as 4.00%, the hundred largest corporate defined-benefit pension plans could become 95% funded, a level not seen in a decade, according to estimates from Milliman, an actuarial consultancy.
Pension plans rely on a discount rate—a calculation representing the present value of future payments—to gauge how likely the manager will be able to pay the enrolled members in the future. A higher discount rate can suggest that the pension funding gaps as it suggests the plan’s portfolio will earn more over time from their fixed-income investments.
According to the National Association of State Retirement Administrators, or Nasra, a pension research group, the discount rate used by many public pensions is about 7%, as of Sept. 30, 2017.
The corporate discount rate, however, is currently at 3.95%, according to Milliman data, and tends to closely follow 10-year Treasury yields at about 2.90%, as U.S. government paper tends to represent a risk-free investment, and therefore serves as a useful benchmark for gauging the merits of owning riskier debt instruments and stocks.
Lee found there were around 29 companies in the S&P 500 SPX, -0.64% whose pension liabilities exceeded 10% of their market value.
U.S. businesses with historically strong labor unions like General Motors Co. GM, +0.48% and Ford Motor Co. F, -0.28% lead the pack. The pension liabilities of both car firms are around 37% of their overall market value as they still stick to increasingly unpopular defined benefit pensions instead of the voluntary 401(k) retirement plans, which can be easier for companies to fund and manage.
Corporate pensions took the spotlight when General Electric Co.’s stock GE, -4.44% tumbled after investors focused on the disastrous state of its balance sheet. Among its many problems, GE’s pension is underfunded by $28.7 billion, FactSet data show.
That has led to some chief financial officers adopting creative solutions. GM, Delta Air Lines Inc. DAL, +0.77% and International Paper Co. IP, +0.04% have issued debt specifically to contribute to their employees’ pension plans.
Part of the move’s logic was to avoid the growing insurance fees paid out to the Pension Benefit Guaranty Corporation, an independent government agency tasked with bailing out failed company pension funds.
See: Why is corporate America issuing debt to fill the holes in pension plans?
But even without the direct intervention of corporate management, there have already been signs that pension funding ratios are on the rise after bond yields commenced a steady climb since December.
After the 10-year yield rose as high as 2.95% in February from 2.45% seen at the turn of the year, Milliman reported the funded status of the 100 largest corporate defined-benefit pension plans also rose to 87.7% in February, from 83.5% in 2017.
Admittedly, higher bond yields have also set off stronger volatility for broader financial markets and could hamper future returns for corporate pension funds. It is unclear whether on the balance, higher discount rates but lower returns will ultimately improve the funding status of pension plans.
But if rising rates don’t unhinge equity markets, driving yields sharply higher, and stock values sharply lower, corporations could look forward to some relief from pension funds, as rates climb, that has been a burden since the start of the 2007-’08 financial crisis.
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