Do Higher Stock Returns Really Lower Funding Costs for DB Pension Plans? Some Simple, but Unpleasant Math

This paper shows that it is possible for a defined benefit pension plan following an immunized fixed income strategy to have lower long-term funding costs than a pension plan following an equity-based investment strategy. This may be possible even if stocks outperform bonds over the relevant time horizon. Current liability payments for an under funded plan raise the required investment hurdle rate needed to maintain a constant funding level. Therefore, under funded pension plans betting on equities need to earn higher asset returns than immunized pension plans at higher funding levels to not further fall behind. Since funding gaps for equity-based investment strategies usually arise under unfavorable business conditions, companies may be unable or unwilling to immediately close them. This leads to a persistence of under funding, thus causing above average returns during a stock market recovery to accrue to an insufficient asset base. Every time an equity-based pension plan finds itself under funded, its potential for lower long-term funding costs over bond strategies is diminished. Lower long-term funding costs due to higher stock market returns can only be assumed if plan sponsors close arising funding gaps as soon as possible. It is furthermore argued that current and upcoming pension regulations as well as investment practices tends to shift the distribution of funding levels towards under funding. Therefore, it is likely that the theoretical possibility of higher funding costs for equity based investment strategies has too often materialized and is partly to blame for the recent shift away from DB to defined contribution plans