US interest rates have been rising after touching historic lows at the onset of Covid-19. For the calendar year 2021, both short-term and long-term interest rates backed up. For corporate America’s pension systems this meant that plan liabilities sank -4.6% based on a 12-year duration. Viewed in combination with the average asset growth of +7.9% based on the P&I Asset allocation for the top 1,000 plans, pension assets outperformed plan liabilities by 12.5%. Wonderful! However, despite significantly stronger average returns for both public +13.8% and multiemployer plans +13.6% (given greater equity exposure) outperformance for the assets of these plans to plan liabilities was much more muted at 6.5% and 6.3%, respectively. Why the significant difference? Regrettably, the accounting rules permit both public and multiemployer plans to use the return on asset assumption (ROA) to value plan liabilities with the average plan using a 7.3% ROA.
If you are a public or multiemployer plan, you’ve skated through the last four decades thinking that a plan’s liabilities grew at a consistent rate – whatever the ROA was at the time. This masking of reality has been harmful, especially for many municipalities and states that have seen contribution expenses ratchet higher and higher. In a year like 2021 when assets growth was wonderful, while liability growth was negative, neither public nor multiemployer plans truly benefited to the extent that they should have because of these antiquated accounting rules. A rising interest rate environment may provide negative headwinds for plan assets, but the impact on plan liabilities should be even worse. But the truth may not be revealed!
The 39-year bull market for the US bonds crushed Pension America as the present value of future liabilities grew disproportionately when compared with plan assets. The dramatic increase in “cost” pushed many corporate sponsors to de-risk with the goal to freeze, terminate, and ultimately transfer plan liabilities. A small subset of corporate DB plans exists today compared to the early 1980s when more than 40% of the private labor force was covered by a traditional pension plan. The good news about rising interest rates is the impact on the present value of pension liabilities which shrink as rates rise improving a plan’s funded status all else being equal.
We’ve communicated often about these accounting irregularities. In fact, Ron Ryan wrote an award-winning book on the subject. Ultimately, we should have one accounting standard in the US to value pension liabilities. The rest of the world uses the accounting rules under IASB, which require a market valuation of assets and liabilities. Perhaps we don’t need to adopt the IASB standards, but it makes no sense to have two different accounting standards (FASB and GASB) in the US based on whether it is a public plan or a corporation. It is beyond time to take the blinders off. Let’s value a plan’s liabilities using a true market rate. It is only when we know the truth can we begin to formulate an appropriate response. We’ve closed our eyes during the longest bond bull market in history. We may just be opening our eyes in time to see what happens to plan liabilities when US rates rise as a secular trend. Forecasted weaker asset growth for the foreseeable future may not be the death knell that has been predicted when you might just have significantly negative liability growth at the same time.