How a Rate Hike May Help Corporate Pension Deficits

When you hear about a coming interest rate hike cycle, the reality is that it is scary and a new unknown for many economic participants and investors. After all, rate hikes have led to serious losses in past decades. This time may be quite different, if Moody’s Investors Service is accurate in its expectations.

A Moody’s report from Monday showed how and why U.S. non-financial corporate pension underfunding will shrink in the next three years. The first consideration is that pensions remain underfunded in America. Moody’s signaled that pension funding levels for rated U.S. non-financial corporate pension liabilities currently remain below 80%.

The good news is that level of underfunded pensions should recover when interest rates start to rise.

Moody’s said in its report:

Since 2008, pension benefit obligations have increased significantly, with discount rates being a major contributing factor. Despite asset returns averaging an impressive 10% per annum since 2008, we believe the funding status of US non-financial corporate pension plans will end this year at 78%.

Here is where the underfunded level of pensions could normalize. Moody’s believes that if interest rates move as it expects, and assuming consistent asset returns, pension plans could achieve a fully funded status in as little as 36 months.
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Moody’s expects Aa corporate interest rates will begin to increase in December, and it believes that the rates will ultimately reach 6% by 2019. Moody’s also gave a scenario for the possibility that rates increase more than it expects, saying that pension plans could be fully funded in just 18 months.

Moody’s concluded:

If discount rates far exceed current expectations and plans become overfunded, plan sponsors could become vulnerable to the risks of surplus cash sitting in pension trust funds. However, we believe companies have been managing this risk over the last several years by keeping voluntary contributions low.

Most investors do not pay attention to corporate pension fund trends. These may not be as influential as they were in decades past, but pension funds remain an integral part of the inflow and outflow sources for the financial markets.