Data review: A steepening discount curve

A look at the changes in key rates and asset returns over the past six months and what those changes mean for corporate defined benefit plans

Despite the day-to-day noise in the financial markets, the overall environment remained positive for corporate pension plans during the first half of 2025. Strong equity returns helped assets outpace the growth of liabilities for most plans. As a result, there is an even more compelling case to explore opportunities for additional de-risking.

Because discount rates were stable year to date, liabilities were not subject to “mark-to-market adjustment shocks.” Remember that just like bonds, the value of liabilities fluctuates as prevailing interest rates move. A simple rule of thumb is for every 1% change in discount rates, plan liabilities tend to change 10%–15%.

Naturally—and again, just like bonds—liabilities also grow in value due to the passage of time.

What is interesting now is that short-duration liabilities grew almost twice as much as long-duration liabilities year to date (3.57% versus 1.85%; see Figure 2).

What’s behind this counterintuitive situation? As is often the norm rather than the exception, discount curves did not shift in a parallel fashion over the first half of the year. (See Figure 3.) This steepening of the yield curve caused short-term cash flows to be discounted at lower yields, resulting in an increase in value. Meanwhile, long-term cash flows were subject to the opposite phenomenon. Therefore, short duration plans (those with relatively more short-term future benefit payments) suffered liability increases larger than those of long-duration plans.

This scenario reiterates the importance of customizing a plan’s hedging program to its liability. Year to date, a short duration plan hedged with long duration bonds would have experienced adverse tracking error—that is, a reduction in funded ratio caused by the lack of fit between assets and liabilities. But a short duration plan that hedged with a well-diversified liability-driven investment (LDI) portfolio—one that is customized to closely match the characteristics of the plan’s liabilities—would likely have seen less volatility in its funded status.

Taking risk off the table

In periods like this—when the overall market trends have been positive and plans likely have benefited from effective liability hedging and strong equity returns—we recommend seizing the opportunity to improve long-term stability. Now is the time to reduce risk, either by moving more plan assets into an LDI portfolio or refining and improving that LDI portfolio to better match the detailed characteristics of the plan’s liability.

The investing risk/reward profile is asymmetrical: Downturns and losses tend to be faster and steeper than upswings and gains. Corporate plans have spent years diligently de-risking and improving their funded status with the help of a positive market environment. We know from history that these market conditions will change and plans that are overexposed to equity downturns may find their funded status diminished. We simply don’t know when those downturns will occur. That makes it critical for plan sponsors to lock in the gains they’ve already achieved as they move steadily toward the goal of fully funded status.

Contact State Street Investment Management to learn more about our de-risking strategies to strengthen corporate pension plans.