Inflation May Be a Welcome Gift for Corporate Defined Benefit Plans
May 5, 2022 — Boston
Plan sponsors should be keenly aware of how raising rates will impact funding status and adjust allocations to hedge for inflation to maintain funding status
While persistent inflation and looming rate hikes have emerged as top concerns for most investors, the same may not be true for corporate defined benefit (DB) plan sponsors, according to the latest Cerulli Edge—U.S. Institutional Edition. Instead, corporate DB plans may benefit from the current environment as inflation and federal intervention provide tailwinds to these pension plans’ financial position (or funded status).
Funded status serves as a proxy to the overall financial wellbeing of a DB plan. Future liabilities are discounted using a rate tied to investment-grade corporate bond interest rates. As such, corporate DB plan sponsors have experienced a decrease in liabilities (beginning in 2021) due, in part, to increasing inflation. As of February 2022, the funded ratio of the 100-largest corporate pension plans reached 102.4%, according to Milliman’s Corporate Pension Funding Index (PFI)—the highest it has been since 2007. Moving forward, Cerulli expects corporate pensions to increase fixed-income allocations to derisk portfolios.
Regulatory tailwinds have come to the aid of plans with funding deficits. On March 11, 2021, President Biden signed a relief bill into law that assisted single-employer corporate DB plan sponsors. The American Rescue Plan Act of 2021 (ARPA)—an extension of the earlier Coronavirus Aid, Relief, and Economic Security (CARES) Act passed a year prior—in effect artificially raised discount rates, translating to higher funding statuses and resulting in decreased required minimum contributions. “The legislation also provides additional breathing room for plan sponsors that can amortize their funding shortfalls over 15 years rather than seven, allowing for further portfolio derisking,” says Jacob Conecoff, analyst.
Corporate sponsors’ cash contributions could also be preserved if inflated input costs can be passed along to the end customer and margins remain steady. “Even in a low-interest-rate environment, plan sponsors are required to make a minimum contribution to plans tied to the present value of future benefit obligations. This is easier now with ARPA,” states Conecoff. ARPA includes a provision on interest rate smoothing using a 25-year average. The Act allows plan sponsors to look back to 2020 and recalculate their contribution requirements based on the narrowed corridors. These changes can materially decrease the required minimum plan contributions, thus relieving some burden for the plan sponsor.
Although corporate DB portfolios are typically more concentrated in domestic fixed income (46.7%) than Taft-Hartley (27.8%), sponsors of both will be exposed to inflationary impact specifically on longer-duration investments. Allocating to specialty vehicles such as Treasury Inflation-Protected Securities (TIPS) or funds containing these instruments can help plans hedge inflation risk. “Corporate DB sponsors must remain aware of the inflationary climate as it relates to their current allocations,” says Conecoff. “Their main considerations should be return impacts, liability effects, and the cash contributions necessary to achieve fully funded status. Inflation will, however, ultimately assist with funding status,” he concludes.
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