Pension Plan Funding to Rise With Interest Rates

U.S. corporate pension plans will remain underfunded at the end of this year but could reach full funding in 2018 if interest rates increase as expected, according to Moody’s Investors Service.

In a report released Tuesday, Moody’s estimates the aggregate funded status will be at 78% at the end of 2015, unchanged from 2014 and only 200 basis points above the 2008 level of 76%. At 78% funded, the pension plans of U.S. rated nonfinancial issuers would be underfunded by $450 billion.

However, the U.S. Federal Reserve has indicated it will raise the fed funds rate by 0.25 basis points on Wednesday. The projected appropriate policy path also indicates a gradual increase in the Fed Funds rate to between 337.5 and 362.5 basis points by the end of 2019.

Therefore, the ratings agency expects the interest rate on “Aa” corporate debt to gradually increase and reach 6% by 2019. Under that scenario, assuming consistent asset returns, pension plans could achieve fully funded status in as little as 36 months.

Alternatively, if discount rates reach 7.5% by 2019, pension plans could be fully funded in as little as 18 months, Moody’s said.

“The risk to our projection remains interest rates (and therefore discount rates) moving up at the much slower pace anticipated by the market and/or companies not achieving their expected 7.75% return on plan assets,” the report cautions.

As Moody’s treats underfunded pensions as a debt-type liability, a funding level of 100% would benefit companies’ leverage metrics, a credit positive.

“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,” Wesley Smyth, a Moody’s vice president and senior accounting analyst, said in a news release. “However, we believe companies have been managing this risk over the last several years by keeping voluntary contributions low.”

Since 2008, the projected benefit obligations of plans sponsored by rated issuers have risen by $703 billion to an estimated $2.1 trillion.