The Fed’s High Interest Rates Are Helping Pension Funds Close the Gap

We also hear endless talk from people waiting with bated breath for the Fed to start cutting rates, which it declined to do at this week’s meeting.

But instead of looking at the problems caused by higher rates, let’s talk about some of the people who are benefiting from them.

To be sure, high rates are hurting the market value of homes, which are many families’ most valuable asset. And high rates are making it harder for people to buy their first homes.

However, high rates have had a little-discussed benefit: helping to improve the financial soundness of pension funds. Increasing funds’ soundness helps both current pensioners (like me) and future pensioners by making pension funds more financially secure and less likely to require bailouts from the federal Pension Benefit Guaranty Corp.

Combine the higher yields on fixed-income assets with current high stock prices and you’ve got a combination that’s hard to beat.

Look at the nearby chart and you see that corporate pension funds are essentially fully funded, according to JPMorgan Chase.

Ten years ago, in 2014, JPMorgan Chase, which gathers statistics filed by the country’s 100 biggest corporate pension funds, showed them to be 82% funded. As of the end of last year, they were up to 99.5%—essentially fully funded. (We’ll discuss the drop from 2022 to 2023 in a bit.)

Now, let’s look at the numbers for state and local pension funds, as reported by the Center for Retirement Research at Boston College.

The center uses data from 229 plans—121 state-run and 108 locally run. It shows a gradual increase to a 78% funding level at the end of last year from 73.1% in 2014. These numbers, which the center says covers 95% of public pension fund assets, aren’t at full funding like corporate plans are. But they’re heading in the right direction.

It’s obvious why rising stock prices make pension funds more financially sound. But the funds’ benefits from higher interest rates are less obvious.

To be sure—three of my favorite weasel words—higher interest rates reduce the market value of bonds that pension funds already hold, which hurts the funds’ financial soundness.

However, higher rates increase the funds’ income from newly purchased interest-bearing securities—and provide a huge but little-known financial benefit by reducing the cost of the funds’ obligations to pay current and future pensioners.

How can this be? It’s because pension funds’ liabilities are based primarily on today’s cost of the pensions they’ve promised to pay in the future.

Let’s say that a fund is obliged to pay $10,000 to a beneficiary 10 years from now. If you discount that $10,000 obligation to today’s value at a 5% rate, the current cost—which is a liability on the fund’s books—is $6,139. However, if you discount that obligation at 7%, the current cost is only $5,083. At 8%, it’s $4,632.

While every plan is different—and state and local plans are sometimes mega-different—discounting the liabilities at a higher interest rate more than offsets the impact that higher rates inflict on the funds’ bond portfolios.

“Plans have taken a hit on their fixed-income portfolios,” says JP Audry, the Retirement Center’s associate director of state and local research, “but equities and other assets have been performing so well that overall, plans’ assets have been growing.”

“There has been a reluctance to embrace the good news about pensions,” says Jared Gross, head of institutional portfolio strategy for J.P. Morgan Asset Management.

Gross and his colleague Michael Buchenholz have been pitching corporations to use their pension fund surpluses in various tax-advantaged ways, including increasing benefits to lure potential employees and to keep current employees happy.

Last year’s change in JPMorgan Chase’s corporate funding statistics are an example of that force at work. Last year’s…