It is hard to believe after the last several extremely eventful years, but 2022 was marked by a number of significant milestones: Ketanji Brown Jackson was sworn in as the first black female justice on the U.S. Supreme Court in its 200-plus-year history; an Andy Warhol (Andy Warhol!) painting sold for nearly $200 million at auction; and Apple became the first company to reach a stunning $3 trillion market capitalization, bigger than the GDPs of all but six countries on the planet.

For institutional investors, 2022 also was a year in which there were significant milestones, not all of them good: stocks and bonds were down together for the first time since 1969, and losses were especially significant (on an absolute basis) for the indices most commonly referenced by corporate defined benefit (DB) plans. As an example, last year was the worst on record for the Bloomberg Long Credit and Long Government Bond Indices, both of which were down more than 25%. The vast majority of the decline for both indices was driven by the rapid rise in interest rates. Adding to eventful moments, the increase in the Fed Funds rate in 2022 marks the swiftest move in Federal Open Market Committee rate hikes since the early 1980s.

How Corporate DB Plan Funded Status Changed Over the Year

For corporate DB plans, which are discounted at high-quality corporate bond yields, 2022 was, for many plans, a blessing in disguise. As liabilities are discounted at higher rates (in some cases virtually double the rate from 12/31/21), the liability value decreases. In 2022 this led to a reduction in liability estimates ranging from approximately 25% to 33% of the prior year’s value. And the asset pool? Well, the performance of assets relative to the liabilities depended almost entirely on a plan’s interest rate hedging strategy.

To track differences in plans (those that elect a higher risk posture and those that elect to hedge a majority, if not all, of their interest rate risk), Callan created two hypothetical fully funded plan models with vastly different investment strategies (see the interactive Callan Corporate DB Plan Tracker for more information about these plans over time). Both were assumed to have the same liability profile—a frozen plan with a liability duration of 14.6 years as of Jan. 1, 2022. The first plan, which we label “Total Return Plan” given its objective of generating a positive long-term return, was invested in a static asset mix containing 30% core fixed income and 70% equities. The second plan, the “LDI Plan” given its objective of minimizing funded status volatility, invests 90% of the portfolio in liability-hedging assets and 10% in equities. The liability-hedging portfolio is designed to target a 100% hedge ratio and is rebalanced quarterly (e.g., as of Jan. 1, 2022, the liability-hedging portfolio was 11% STRIPS 20+ years, 13% long government, and 76% long credit).

Over the year, Callan rolled the liability forward for expected benefit payments, movements in interest rates, movements in corporate bond spreads, and changes in the yield curve (FTSE pension discount curve). As we alluded to earlier, the single equivalent discount rate for our proxy liability went from 2.70% at year-end 2021 to 5.23% at year-end 2022. Therefore, it is not surprising that there were differences in the plans’ funded statuses right out of the gate.

Beginning in 1Q22, a hawkish Fed, signs of uncontained inflation, and Russia’s unprompted invasion of Ukraine sparked a sell-off in both risky assets and in rates. By the end of 1Q22, the Total Return Plan’s funded status had increased to 105.7% while the funded ratio of the LDI Plan remained almost unchanged from the beginning of the year at 99.7%. As 2Q came into full swing, the war between Russia and Ukraine intensified and inflation prints globally shocked the market and central banks into swift action. Equity markets ended the quarter with double-digit losses, and long-duration assets mimicked 1Q’s double-digit losses as well. Both the Total Return and LDI Plans lost some ground, driven by the sell-off in return-seeking assets, but the Total Return Plan remained above 100% funded (at 104.3%), while the LDI Plan, which lost another 2.2 percentage points of its funded status, ended the quarter at 97.5% funded.

Rates sold off again in 3Q, and we continued to see the benefit to plans that implemented a less than 100% interest rate hedge as equities fared somewhat better than hedging assets during the quarter. Finally, in 4Q, the idea that the Fed was nearing the peak of its hiking cycle buoyed risk assets, propelling a significant increase in the Total Return Plan relative to the LDI Plan. Net/net, for a plan that started the year with an emphasis on growth (high exposure to return-seeking assets) and was less than 100% hedged, the riskier posture was rewarded by funded status increasing from 100% to 111.7% in Callan’s simulation. The LDI Plan, which emphasizes low funded status volatility, largely achieved that during the year despite discount rates nearly doubling. The LDI Plan lost a little ground, falling from 100% funded to 97.3% funded at year-end.

Interest rate management was not the only tool to take note of in 2022, which marked the largest year on record for premiums written in the pension risk transfer market. Much of this activity was planned in 2021 when rates were lower and plans were coming off of favorable glidepath progression from 2020 and 2021’s very short, COVID-related interest rate and credit cycles. 2022 ended with an estimated $55 billion in pension risk transfer premiums written, including several banner deals in 3Q.

But many plans were able to reduce their liability obligations by doing nothing more than continuing in an underhedged position. As a result, funded status improved for many plans. In fact, for plans less than 100% hedged, from an interest rate perspective, it is likely that their funded ratio got better in 2022.

The results of this year illustrate why investment strategy matters. For a plan that was 100% hedged (from an interest rate perspective) and down 25% to be celebrating seems counterintuitive. But it’s because the investment strategy worked! For the LDI plan the funded ratio moved +/-2 percentage points for the year. That is an incredible outcome given that discount rates essentially doubled and the yield curve inverted during the year. And for the plan that elected not to hedge as much interest rate risk? Well, that was generally a home run with funded ratios increasing by 10 percentage points or more for some clients, although there was a chance the outcome could have been different. Ask most fixed income managers and they will agree that managing duration is typically a low information ratio trade. It is hard to account for exogeneous factors such as wars, unexpected central bank rhetoric, and supply shortages. However, selecting a long-term investment strategy and adhering to it generally is a winning combination. We will continue to track our plans over the year, and we will post regular insights and funded status attribution in 2023 in our DB Tracker.