The hundred largest corporate defined benefit pension plans in the United States held assets of $1.296 trillion against obligations of $1.156 trillion at the end of July, a funded ratio of 112.1% and a surplus of $139 billion. A year earlier the same measure stood at 104.3%.

That improvement happened during a period when long bond prices were falling hard. It is the clearest example available of a rule most investors know in theory and rarely apply: whether rising rates help or hurt you depends entirely on whether you have liabilities.

A pension is a bond portfolio with a bond-shaped debt

A pension promise is a stream of payments stretching decades into the future. To put a present value on it, the plan discounts those payments using current high quality corporate bond yields. When yields rise, the present value of the promise falls.

The discount rate for these plans was 6.02% in July, up from 5.61% a month earlier and 5.55% a year before. That single forty-one basis point move in July cut liabilities by $52 billion, which more than covered $27 billion of investment losses in the same month. The plans got healthier on a month when their assets went down.

This is the same arithmetic that has been punishing individual bondholders, run in reverse. A retail investor holding long Treasuries owns the asset side of a duration position with no liability underneath it, so a rising yield is pure loss. A pension owns both sides, and its liability has more duration than its assets, so a rising yield is a net gain.

What plan sponsors do with a surplus

Whitmore's Watchlist:
PRU (Prudential Financial, Inc.): One of the largest writers of pension risk transfer business in the country.
MET (MetLife, Inc.): The other major counterparty when a company hands its pension obligations to an insurer.
CRBG (Corebridge Financial, Inc.): Retirement and annuity focused, geared to the same rates driving all of this.

A company with a fully funded plan has options it did not have in 2012, and the most common one is to stop running the plan at all. In a pension risk transfer, the sponsor buys a group annuity from an insurer, the insurer assumes the obligation to pay the retirees, and the liability leaves the corporate balance sheet permanently.

That transaction is priced off the same yields. Higher rates make the annuity cheaper for the sponsor to buy, so a surplus and a low purchase price arrive together, which is why de-risking activity tends to cluster in periods like this one. The flow of business goes to a small group of large insurers.

For shareholders of the sponsoring companies, the effect is quieter but real. A pension deficit is a claim on future corporate cash flow, and analysts treat it as debt. Removing it improves the quality of reported earnings and frees cash that was going into contributions. For the insurers on the other side, it is long-dated business written at attractive rates.

Where it can turn

Two things would undo this. The obvious one is falling rates, which lifts the present value of the obligations faster than a bond portfolio gains, putting plans back into deficit. That is why a well-run plan with a surplus generally shifts its assets toward long bonds that match the liability rather than holding on to equities, locking the position rather than pressing it.

The second is credit. The discount rate uses high quality corporate yields, so a widening of corporate spreads mechanically raises the discount rate and improves the funded ratio on paper at exactly the moment the plan's own corporate bond holdings are losing value. Funded status looks best when credit conditions look worst, which is worth remembering before treating a single monthly reading as a measure of health.

The broader point extends well past pensions. Anyone with a long-dated obligation, an insurer, an endowment with spending commitments, a household planning thirty years of retirement income, has been quietly helped by this year's bond selloff even while their bond statements looked terrible.

Whitmore's Take: Rising rates cut the value of a bond and cut the value of a future obligation by the same mechanism. Worth asking whether your own plan has liabilities on the other side of its assets, because that determines which half of this year you actually experienced.

Written by Daniel Whitmore
Millionaire Insiders