Chasing liability growth rates 

• Defined benefit (DB) pension plans face significant challenges as rising interest rates increase liability growth rates, complicating investment policy design.
• Plan sponsors may need to consider strategies such as increasing allocations to higher returning assets or adjusting the balance between return-seeking and liability hedging investments to navigate the current environment.
• Key metrics such as Surplus Volatility and Surplus Return are essential for assessing the risk-return trade-offs of investment options.
• A thorough evaluation of the impact of higher interest rates and declining equity risk premiums on cash funding, funded status, and pension expenses is crucial for aligning strategies with sponsor objectives and improving outcomes.

To maintain or enhance the funded status of a DB pension plan without additional cash contributions, asset returns need to exceed the liability growth rate, which consists of interest cost, annual expenses, and, for plans with ongoing accruals, the service cost. While recent increases in interest rates have generally been favorable for plan sponsors, leading to improved funded status levels, they have also caused significant increases in liability growth rates due to higher interest cost. Below (Figure 1) are the historical discount rates used in calculating the interest cost component of the liability growth rate for three sample plans. Rates as of December 31, 2024, represent the high-water mark over the last ten years and are more than 3.00% higher than the levels observed at the end of 2020.

_{Source: Mercer}

Conversely, the expected returns on equity have not kept up with the higher level of rates, resulting in lower equity risk premium expectations (Figure 2). 

_{Asset class expected returns are hypothetical, shown only for illustrative purposes at the general-market level only. Hypothetical returns shown are based on Mercer’s January 2025 Capital Market Assumptions. This is not meant to represent Mercer’s performance or any illustrative/actual portfolio. It is not a recommendation, offer or solicitation to buy or sell any securities or to adopt the illustrative portfolio. There can be no guarantee targets will be achieved. Past performance is not a guarantee of future results.}

This combination of factors has increased the difficulty of designing an investment policy that meets plan sponsors' objectives of maintaining or improving funded status without contributing additional funds. 

We typically utilize two key metrics to assess the risk-return trade-offs of investment policy options: Surplus Volatility and Surplus Return. Surplus Volatility measures the potential change in a plan’s surplus or deficit due to fluctuations in market conditions, primarily equity returns, interest rates, and credit spreads. It reflects how these factors impact both the asset portfolio and the liability values. Surplus Return is the expected asset return in excess of the liability growth rate, depending on the asset portfolio return expectations, the current funded status, and the expected liability growth rate. We can also evaluate the efficiency of alternative portfolios by comparing the Pension Sharpe Ratio, defined as the ratio of the Surplus Return over the Surplus Volatility. A higher ratio indicates a portfolio is generating more excess return per unit of funded status risk.

Below is an example of what these metrics might look like for a typical closed pension plan using return expectations as of January 1, 2025.

_{For illustrative purposes.¹ Surplus Return is equal to the expected return on assets times the funded ratio, minus the liability growth rate. ² Pension Sharpe Ratio uses surplus return based on the arithmetic return, rather than geometric.}

As you can see in the table above, the 60% return-seeking / 40% liability hedging allocation generates a negative Surplus Return, leaving the sponsor to make up the difference with funding if the expected returns are realized. While the results will vary depending on plan specifics, the liability growth rates associated with the current market environment make it challenging to generate sufficient returns to improve or, in some cases, even maintain the funded status level. For underfunded plans or plans with more significant ongoing accruals, the challenge is even greater.

One potential strategy for improving outcomes is to increase the allocation to equity. The chart below (Figure 3) compares the trade-off between Surplus Return and Surplus Volatility using an efficient frontier based on Mercer’s Capital Market Assumptions (CMA) as of January 2021 and as of January 2025. As illustrated, while still producing higher Surplus Return outcomes, the potential benefits of increasing the equity allocation have diminished, and the efficient frontier is considerably flatter due to current market conditions. In fact, in the current environment, even the more aggressive allocations do not result in positive excess returns for the sample plan modeled.

_{For illustrative purposes only. Based on Mercer Capital Market Assumptions and the illustrative plan described above with interest rate hedge ratio targets adjusted based on the allocation.}

What actions can be taken to improve this situation? There are no straightforward answers. For some plan sponsors, allocating to higher returning assets, including high tracking error managers, or looking at ways to harness the illiquidity premium may enhance return expectations, but not all can accommodate the associated illiquidity and governance considerations. Others may need to consider increasing the allocation to return-seeking assets, even if the trade-off is not as favorable as it once was. There are also plan sponsors who are willing to take leverage within their return-seeking assets, and as a result utilize “portable alpha” strategies on top of equity allocations.

Regardless of where a plan sponsor’s risk appetite lies, we believe that evaluating the impact of higher interest rates and the declining equity risk premium on key outcomes—such as cash funding, funded status levels, and projected pension expense—is a valuable starting point. Understanding the implications and exploring all available options, including additional funding, can lead to better alignment with objectives and risk tolerances. 

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