US Corporate Pension Review and Preview 2024
Executive Summary
Funded levels have risen notably in the US corporate defined benefit (DB) pension universe in recent years given the surge in interest rates and rebounding equity values. Many plans have moved down their glide paths and are at or close to their “end state,” raising several questions from plan sponsors around the strategy they may wish to employ given this position of strength, such as:
- Should they hibernate their plan?
- What should an “end state” portfolio look like?
- Should they explore some sort of risk transfer?
- How might they monetize surplus in the plan?
All of these are valid and important questions. We believe that the approach sponsors should consider in evaluating an appropriate asset allocation strategy is no different now than at other funded levels, a plan for all seasons so to speak, although the output would likely be much different based on the answers to the questions outlined above.
As we do every year, we take this opportunity to review the just completed year and highlight themes that we believe will be relevant for the upcoming year. In this report we:
- provide context around the state of the US corporate pension system as we close out 2023 and look towards 2024,
- examine strategies employed by sponsors whose plans are in an overfunded and closed / frozen situation,
- outline a framework for considering an appropriate asset allocation and investment strategy for a plan near its end state, or at any state for that matter, and
- review potential use of surplus options, including the economics behind reopening a plan.
I. Important Inflection Point for the US Corporate DB System
Rising interest rates over the past few years combined with the 2023 rebound in equity values has bolstered corporate DB plan funded ratios, lifting them to their highest level since before the global financial crisis. Our work would suggest that the aggregate GAAP funded status of the US corporate DB system was 106% as of year-end 2023, nearing the level back in 2007, and about two thirds of all plans are now either fully or overfunded (see Exhibit 1).
Source: Goldman Sachs Asset Management and company reports. Based upon the US (when specified) defined benefit plans of S&P 500 companies. For illustrative purposes only. The 2023 (E) figure is preliminary and unaudited as of December 31, 2023. Actual results may vary significantly from the information presented above. Illustrations reflect one possible outcome and reflect a number of assumptions which are disclosed therein. Goldman Sachs is not providing actuarial services in connection with providing the information contained therein.
In many ways, despite a similar aggregate funded status, the system is even healthier than it was back in 2007. Since that time, many plans have shifted their asset allocation and investment strategy to be more asset / liability focused. This has resulted in lower allocations to equities and higher allocations to high quality fixed income (see Exhibit 2). Consequently, the funded status volatility of many plans has declined notably. Steep declines in interest rates or equities would not have the same impact on a plan that they would have had 15 or 20 years ago given better alignment of plan assets with plan liabilities.
Source: Goldman Sachs Asset Management and company reports. As of December 31, 2023. Based upon the US (when specified) defined benefit plans of S&P 500 companies. For illustrative purposes only. Illustrations reflect one possible outcome and reflect a number of assumptions which are disclosed therein. Goldman Sachs is not providing actuarial services in connection with providing the information contained therein.
In addition, the growth of the US and global economy over the past 15 years has augmented the value of many of the sponsors of these plans. As a result, the relative size of gross pension obligations for individual companies has shrunk versus the size of the plan sponsor as defined by the firm’s equity market capitalization. Consider that in 2007 the median US projected benefit obligation (PBO) as a percentage of a sponsor’s market capitalization for companies in the S&P 500 with DB plans was over 8%. That median percentage had fallen to less than 5% as of 2022.
The US Federal Government’s insurance program has also experienced a dramatic turnaround. After being in a deficit position for 16 consecutive years from 2002 through 2017, the Pension Benefit Guaranty Corporation’s (PBGC) single-employer program has posted a surplus in each of the last six fiscal years, topping out at almost $45 billion as of fiscal year-end 2023 (see Exhibit 3). In its recently released Projections Report, the PBGC estimates the net financial position of the program will exceed $60 billion by 2032.
Source: Pension Benefit Guaranty Corporation and Goldman Sachs Asset Management. As of December 2023. The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this material.
This is all good news for participants, plan sponsors, and the PBGC. Benefits are more secure, the financial exposure sponsors face from these plans has been in some cases reduced, and the soundness of the insurance backstop lessens the chance of the need for government assistance for the foreseeable future.
But “fully funded” should not be confused with “no risk.” History is littered with examples of companies that had overfunded (and sometimes frozen) plans, but subsequently saw that position of strength deteriorate when interest rates and / or equities fell, and deficits reappeared. Organizations that should never have needed to make any future contributions to their plans were suddenly faced with mandatory funding requirements, higher PBGC variable-rate premiums, increased pension expense on their income statements, and the recognition of liabilities on their balance sheets.
In addition, despite the current position of strength and solid financial position for the PBGC, the cost to the sponsor of maintaining participants in a DB plan has continued to rise. As seen in Exhibit 4 below, PBGC flat-rate premiums, the premium paid each year for every participant in a plan, will now exceed $100 in 2024. This premium rate has more than doubled since 2014, growing at a compounded annual growth rate of about 7.5% during that time. For most Chief Financial Officers, any cost that is growing at that annual rate over a decade will likely attract their attention. While several trade groups, including the American Benefits Council, have advocated for a reduction in these premiums given the strong financial position of the PBGC, the premiums nonetheless continue to increase each year given they are indexed to inflation.
Source: Pension Benefit Guaranty Corporation and Goldman Sachs Asset Management. As of December 2023. Flat-rate premiums are subject to indexing. Past performance does not predict future returns and does not guarantee future results, which may vary.
II. Examining the Asset Allocations of Well-Funded and Closed / Frozen Plans
This all contributes to the “now what” question, as in “what do we want to do with the plan now?” Due to the improvement in funded levels over the past few years, many plans have moved down their “glide paths” or “journey plans” and are either at or near their “end state.” Plan sponsors that were holding off on hedging are likely now in a better spot than they were just a year or two ago.
For plans that are closed / frozen and are maintaining a de-risking plan, they may be pondering a number of questions, such as:
- How do I construct an end state portfolio including private assets and allocation to custom LDI?
- At what funded level should my end state be?
- Should we be thinking about diversifying our liability hedging portfolio beyond public investment grade credit and US Treasuries?
- Should we be thinking about some sort of pension risk transfer / annuitization?
- At what funding level can I complete a risk transfer transaction without increasing expected cash contributions?
- If we do pursue a pension risk transfer, what are some of the considerations we should have on our radar?
- Are there allowable uses of our surplus now that we are at our end state and overfunded?
- Once we feel like we have locked down our DB end state game plan, should we be taking a closer look at our defined contribution plan?
This is an important conversation to have. C-Suite executives are often battling multiple fires at the same time, such that spending time on their overfunded DB pension plan may not be something high on their “to do” list, but it should be. As noted earlier, fully funded does not equate to riskless. In addition, the position of strength that many plans find themselves in today may allow sponsors to consider other strategies for their plans that were not on the table even a few short years ago.
To help guide this conversation, we went into our database of US DB pension plans for S&P 500 companies as of the end of 2022 and screened for plans that were over 100% funded on a GAAP basis and, to our knowledge, closed or frozen. This seemed like reasonable criterion to identify plans that may be at or at least nearing the end point on a glide path.
In Exhibit 5, we have detailed the equal-weighted target asset allocation for this population of overfunded and closed / frozen plans. As seen in the pie chart, in aggregate these plans target about two-thirds fixed income and one-third return-seeking assets like public equities and alternatives, such as private equity and real estate.
Source: Goldman Sachs Asset Management and company reports. Based upon the US (when specified) defined benefit plans of S&P 500 companies. Population includes 31 plans in the S&P 500 that, based on our review, are primarily closed and frozen and have a GAAP funded status in excess of 100% as of the end of 2022. For illustrative purposes only. Illustrations reflect one possible outcome and reflect a number of assumptions which are disclosed therein. Goldman Sachs is not providing actuarial services in connection with providing the information contained therein. Targets are subject to change and are current as of the date of this document. Targets are objectives and do not provide any assurance as to future results.
What may be more interesting than the average target asset allocation are the ranges observed for each asset class, also detailed in Exhibit 5. What could potentially drive such a wide divergence in strategies for plans that are seemingly in similar positions? Some possible explanations include:
- Expected Return on Asset (EROA) Implications: Shifting assets from equities to fixed income as part of a de-risking plan will often necessitate lowering the EROA assumption, which could increase pension expense on the sponsor’s income statement. That may lead some sponsors to maintain relatively higher exposure to return-seeking assets despite being overfunded and closed / frozen.
- Future Vision of the Plan: Sponsors that envision a substantial partial pension risk transfer or a complete plan termination may be likely to lean more heavily into liability hedging fixed income. A plan that intends to run this liability off itself over the next 50+ years may be more inclined to maintain a higher allocation to equities to account for potential adverse actuarial experience as well as ongoing plan expenses. A decision to change course and reopen the plan could also provide a reason to maintain exposure to higher return-seeking asset classes despite currently being closed or frozen.
- Materiality of Plan to the Sponsor: Sponsors where the plan is outsized versus the footprint of the organization may be more inclined to minimize funded status volatility. Lower materiality may translate into a willingness to accept more funded status volatility and, therefore, more equities and higher return asset classes.
- Use of Surplus Options: At times, an overfunded plan can be combined with an underfunded plan assumed through an acquisition. As such, some sponsors with overfunded plans may still be incentivized to seek higher returns through equities and other return-seeking asset classes in order to grow any surplus. In addition, as explored later, there are other possible use of surplus options, such as potentially reopening a plan, that could lead a sponsor to maintain more of a risk-on orientation despite being overfunded and, at least at the time, closed or frozen.
III. Plotting an “End State” Allocation
For plans that are now overfunded and frozen or have been closed for a significant period of time with perhaps no thought of potentially reopening, many are wondering what that end state or steady state portfolio should look like. In particular, crafting a split between liability hedging and returning-seeking assets and determining how large a role derivatives should play in the portfolio.
We would postulate that the process a plan goes through in answering those questions is no different than at other points on their funded status glidepath or irrespective of whether the plan is open or closed or frozen. Our illustrative framework focuses on minimizing funded status risk relative to target surplus return. While the level of target surplus return may vary for a number of factors, we believe it is important to set a minimum target surplus return.
To be self-sustaining, we believe a minimum surplus return consists of annual expected expenses and service cost, if applicable, of the plan. We would also suggest a buffer for adverse actuarial events. In practice, we typically see this return achievable, when allowing for an appropriate level of downside funded status buffer relative to the portfolio volatility, between 102% and 105% funded. This brings us to two points: 1) we are not convinced material de-risking should occur immediately at 100% funded as that limits the necessary upside for buffer, and 2) the hibernation funding level is typically lower than the plan termination cost for at least a subset of plan liabilities. To the extent that a plan is looking to utilize the hibernation portfolio to grow surplus for strategic uses, an additional 50 to 100 bps may typically be achievable without significant additional risk.
Exhibit 6 presents this framework pictorially.
Source: Goldman Sachs Asset Management. For illustrative purposes only. The percentages are for illustrative purposes only and should not be construed as investment advice or a recommendation. It is only intended to demonstrate how asset allocation and derivatives positioning decisions may be intertwined.
The starting point for the analysis is dependent on three factors – what is the target surplus return, what is the plan’s ability to take on illiquidity, and what is the target interest rate hedge ratio? The determination of these metrics will depend on various factors, such as the plan funded status and the sponsor’s appetite for risk. But once these metrics are determined, everything else essentially falls out. In the illustrative example above, we assume the plan is fully funded, at its “end state,” and therefore would wish to maintain an interest rate hedge ratio of 100%, and has the ability and desire to utilize its cash flow profile to take on a thoughtful amount of illiquidity.
The amount of assets to be allocated to the growth or return-seeking portfolio should be suitable to meet the surplus return target. Whatever is not needed for those purposes can be allocated to the liability hedging portfolio. The difference between the desired interest rate hedge ratio and the amount of hedging that can be accomplished by the physical fixed income securities can then be filled in with derivatives like Treasury futures or interest rate swaps.
Obviously, the underlying asset classes of the return-seeking and liability hedging portfolio would need to be developed in greater detail. This introduces many other questions such as the mix of public and private assets as well as what other assets can be included in a hedging portfolio beyond public investment grade debt. We believe adding private credit assets to LDI, at a minimum private investment grade, can help reduce the burden on the growth portfolio while providing credit diversification, and we have seen this as a significant trend in recent years. The trade-off to adding various types of private assets for a given liquidity budget can be evaluated with the same surplus return and surplus risk framework across different portfolio options.
IV. Use of Surplus and Other High-Class Considerations
Moving into an overfunded position has presented some plans with a situation they may not have had to address in over a decade – what can they do with surplus? Given the restrictions placed on overfunded pension assets, plan sponsors cannot take out the surplus to use for general corporate purposes without paying punitive excise taxes.
Nonetheless, there are some allowable uses of DB pension surplus when the right conditions are met. These could include:
- funding retiree health care obligations,
- funding a qualified replacement plan,
- facilitating a pension risk transfer, or
- combining with an underfunded plan as part of an acquisition.
Of course, one easy use of surplus is to pay for future benefit accruals. For plans that are accruing new benefits, those future benefits have essentially been pre-funded. But what if your plan is closed or frozen? Reopening the plan is one potential way to access that surplus.
Before diving into the math, let us acknowledge one important fact. Despite conventional wisdom that corporate DB plans are going away, many companies still maintain open plans. We recently conducted an analysis comprising 100 companies with some of the largest DB plans in the US. We endeavored to classify each company as being in either an open, closed, or frozen state with respect to their pension plan. This is a bit more complicated than it sounds since many companies maintain multiple DB plans and often they themselves may have a mix of open, closed, or frozen plans.
In our analysis, we classified each company based on either the status of its largest plan or the status of a majority of its plans. As seen in Exhibit 7, 39% of the companies in the population were classified as open and an additional 34% were closed, but still accruing benefits for at least some employees. Only a little over a quarter were classified as being frozen.
Source: Goldman Sachs Asset Management and company reports. As of December 31, 2023. Based upon a sample of the US DB plans of 100 US companies in the S&P 500. For illustrative purposes only. For illustrative purposes only. Performance results vary depending on the client’s investment goals, objectives, and constraints. There can be no assurance that the same or similar results to those presented above can or will be achieved. Goldman Sachs does not provide accounting, tax or legal advice. Please see additional disclosures at the end of this material.
In the IBM case, in which it was reported that it reopened its DB plan, its qualified DB plan was approximately $5 billion overfunded as of the end of 2022. Based upon what has been reported in the press, the company will no longer be making automatic or matching contributions to its defined contribution plan but will instead be instituting a cash balance DB plan with a 5% payroll crediting rate, a 6% interest crediting rate for the next few years, and then an interest crediting rate tied to the 10-year US Treasury yield (with a 3% floor) thereafter.
As new benefits are accrued in the DB plan, they have essentially been pre-funded (for a finite period) due to the current overfunded position. With a defined contribution plan, matching or automatic contributions come due every year, irrespective of market fluctuations. This switch can allow the company to monetize its DB surplus in a tax-efficient manner, essentially swapping DC contributions for DB benefits that have been pre-funded.
For plans that are overfunded and frozen, the math may make sense, as may the use of a cash balance DB plan for implementation. While many sponsors have moved away from a final average pay formula for the accrual of benefits, a cash balance plan is typically less volatile. The corporate DB plans that live on in the future may likely be those of a cash balance nature.
For a plan sponsor willing to consider capital structure and compensation planning holistically, a well-managed pension plan can be considered a strategic asset. We believe this value is not limited to a significantly overfunded pension, but rather can be applied to a pension put thoughtfully into hibernation.
We define a simple hibernation scenario as follows:
- ~$2.1 bn frozen pension funded at 102%
- Decision to replace $15 mm in annual DC costs with cash balance pension benefits
- A hibernation portfolio seeks to minimize surplus risk relative to a 100 bps gross surplus return to cover new cash balance accruals and 20 bps of annual expenses
- A portfolio may be constructed without adding further surplus growth buffer for adverse actuarial events which may increase the level of growth assets desired and target surplus return
Source: Goldman Sachs Asset Management. Targets are subject to change and are current as of the date of this paper. Expected returns are estimates of hypothetical average returns of economic asset classes derived from statistical models. There can be no assurance that these returns can be achieved. Actual returns are likely to vary. Please see additional disclosures. All numbers reflect Multi-Asset Solutions’ strategic assumptions as of September 30, 2023. For illustrative purposes only. Other portfolio allocations besides the illustrative allocations shown above may also be considered. This does not constitute a recommendation to adopt any particular asset allocation. All illustrations of funded status, surplus and related funding information are based on actuarial data provided where appropriate. Goldman Sachs is not providing actuarial services in connection with providing the information contained therein.
As illustrated in Exhibit 9, this hypothetical plan is expected to be able to pay for benefit accruals in a hibernation state.
- Utilizing a hibernation approach while replacing DC benefits, the company could save $170 mm+ in cumulative cash contributions
- Expected downside risk does not materially increase (estimated funded status volatility increase of <2% or ~$40mm in risk which can be thought of as covered by the “reserve” of the surplus in the plan)
- A significant portion of the value stems from the legacy benefits in place. Without the accrued and funded benefits, the asset base would not be able to support the same level of cost. For example, if the pension were half the size (i.e., $1.05 bn) a $100 mm difference in funding position would be expected at year 10, significantly reducing the cumulative cash savings
Source: Goldman Sachs Asset Management. For illustrative purposes only. Illustration assumes a 6.75% asset return, 5.90% liability return, 4.5% cash balance interest crediting rate, and 3% salary scale. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. Expected returns are estimates of hypothetical average returns of economic asset classes derived from statistical models. There can be no assurance that these returns can be achieved. Actual returns are likely to vary. Please see additional disclosures. All numbers reflect Multi-Asset Solutions’ strategic assumptions as of September 30, 2023.
CONCLUSION
Many corporate defined benefit pension plans are at an important inflection point given the rise in funded levels over the past few years. As sponsors evaluate potential actions to take given this position of strength, they may wish to consider the potential benefits of:
- Continuing to hedge interest rate risk in a custom fashion to minimize uncompensated pension risk.
- Building hibernation portfolios with a focus on minimizing surplus risk for a target level of surplus return and evaluating the role of illiquidity and alternatives in the LDI portfolio.
- Considering opportunities for pension surplus.
