In focus

Why fully-funded US pension plans could give bonds a boost


With interest rates at historic lows, market commentators have had cause to wonder whether there is any value left in holding bonds. One traditional argument is their inherently lower risk and lower volatility characteristics, but even this has come into question in the recent past.

These factors are, however, relevant once again. US pension funds are currently back at fully-funded levels. The Milliman Pension Funding Index of the 100 largest defined benefit plans sponsored by US public companies hit 98.8% at the end of May, the highest since the 2008 Global Financial Crisis.

This high funding ratio, meaning the amount of assets held by the pension funds is almost equal to liabilities, gives pension funds leeway to move out of equities and into bonds. We have already started to see this materialise.

Given these largest plans have $1.8 trillion in assets and all private defined benefit plans total approximately $3.5 trillion, a reallocation of 5% of plan assets would bolster demand for long-dated Treasuries and corporate bonds by approximately $175 billion.

This expected shift of assets does, however, raise questions.

  1. Why would pension funds buy bonds with yields close to historical lows and at levels half what they were when plans were last fully funded in 2007?
  2. Why further decrease equity allocations, having already reduced them in favour of fixed income since 2007?

Four reasons US pension funds will shift from equities to bonds

  1. These plans have lived through significant volatility in their funded status over the last decade. Funded status moved down to approximately 72% in 2012, swinging to 94% in 2016 back down to 82% in 2020. Such large moves may make them less inclined to “roll the dice” again.
  2. Increased shareholder focus on these obligations will lead pension plans to act. Accounting changes have driven a much greater recognition of the impact of changes in the value of these liabilities on corporate financial statements and acceptance that the risks should be managed explicitly. Notably, liability-driven investment (LDI) approaches, which embed a “de-risking” glide path by shifting progressively into fixed income as funded status improves.
  3. Running deficits in the future will incur greater direct costs through increased premiums charged by the statutory “re-insurer” (the Pension Benefit Guarantee Corporation).
  4. Continuing to maintain the significant risks inherent in current asset allocations would only “pay off” if discount rates rose and/or equities outperformed. There is inherent career risk in not taking some chips off the table at this juncture.

While the prospects for elevated inflation could potentially drive these outcomes, they have been well-recognized and discussed in the markets, and it remains to be seen whether they are already fully incorporated into asset prices. 30-year Treasury yields are up approximately 100 basis points (bps) since the middle of last year and the Russell 3000 price/earnings ratio at 23.4 is 35% higher than it was at end 2007.

Although inflation could push discount rates higher from here, making bonds less attractive, the technical demand for long-dated fixed income remains strong. Foreign investors can pick up the highest levels of additional return, taking into account currency hedging costs, over their domestic bonds available in over five years. A provision of the recently passed American Rescue Plan Act is expected to add additional demand for long bonds in excess of $80 billion over the next two years.

The events of the last year have led to a market environment which is forcing pension plans to act. This is likely to see increased allocations to fixed income assets. We expect to see large flows into long duration bonds in particular, a trend that has already begun, but which will grow in magnitude in the coming quarters.