What drives funding risk in a defined benefit pension plan?

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AcadiFi · Accepted Answer

Funded ratio = plan assets / projected benefit obligation (PBO). It moves with three drivers: asset returns, liability discount rate changes, and actuarial experience vs assumptions. For Willowbrook Steel (95% funded, $6.2B assets, $6.5B PBO), a 10% equity drawdown with a 50% equity allocation reduces assets by $310M to $5.89B. Simultaneously, if long corporate AA yields fall 50bps, liabilities duration 13 grow by 6.5% to $6.92B. Funded ratio drops from 95% to 85% — a 10-point move driven by both legs. Contribution requirements then kick in: US corporate plans use minimum required contributions (MRC) under ERISA/PPA rules plus IRS §430 funding targets. A 15-point underfunding gap of $1B at a 7-year amortization would add ~$160M per year to contribution — enough to dent a mid-cap sponsor's free cash flow materially. That is why sponsors dislike funded-ratio volatility even more than asset volatility: accounting (ASC 715) smooths P&L but cash contributions do not smooth. LDI programs match liability duration through long Treasuries, STRIPS, interest-rate swaps, and swaptions. Completion mandates close residual gaps. Plans also hedge inflation (TIPS, inflation swaps) and longevity (longevity swaps, reinsurance). The objective is not to eliminate risk but to retain only risks that are rewarded — usually the equity risk premium scaled by surplus cushion.

What drives funding risk in a defined benefit pension plan?

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