Capital markets, reframed: A corporate defined benefit perspective

The average U.S. corporate DB plan ended 2025 overfunded at 108%¹

This milestone, which hadn’t been reached for almost two decades prior to 2024, has fundamentally changed the priorities of plan sponsors and the questions they need to ask.

When funded status improves, the traditional playbook calls for reducing equities and increasing fixed income hedging. However, today’s market dynamics complicate those moves. Things like persistent inflation risks, evolving rate uncertainty, concentrated equity gains, and historically tight credit spreads carry consequences for funded-status volatility, contribution risk, and long-term policy decisions.

Let’s explore the four capital market dynamics we believe merit the focus of DB plan sponsors, and why they matter from a pension governance and risk-management perspective.

Credit spreads have remained rather tame

• Despite heightened volatility and geopolitical uncertainty, credit spreads are relatively contained, especially compared to equities, and have tightened to near historic lows.
• Spread risk feels asymmetric at the moment, as they have reached a lower bound level that limits further compression based on historical standards. Yet when a crisis hits, the widening spread is severe and, at times, north of 200 basis points² (see Exhibit 1).
• Liability valuations are driven by changes in high-quality bond yields. When yields fall, liabilities rise and vice versa. A large component of a corporate bond yield is its spread over Treasuries. If spreads tighten, liability increases (everything else equal).
• The bottom line: Tight spreads create unique dynamics for hedging pension liabilities, with risks more skewed to spread widening events, which actually reduces liability values temporarily. So, do plans consider reducing the credit component of the liability hedge while maintaining the tight interest rate hedge? Can they nimbly increase it if spreads widen? These are all important considerations for sponsors and their investment partners to discuss.

Exhibit 1: Credit spreads act as a gauge of financial stress and investor risk appetite

Fed expectations continue to shift

• Over the last six to nine months, we’ve gone from “how many rate cuts in 2026?” to now a hold for the foreseeable future, begging the question of if we are moving to a neutral posture or a rate hike. Markets are starting to price in rate hikes as of mid-May after strong inflation readings in addition to other strong data, such as an improving manufacturing sector and stabilizing labor markets.
• Inflation remains elevated and sticky and above the Fed’s preferred 2% level with greater risks to the upside driven by lingering effects on oil supply and pricing post any conflict resolution, which only exacerbates the existing dynamics that were already keeping inflation above the Fed’s target. But the reality is, can the Fed continue looking through oil after looking through tariffs?
• Following the April rate decision, Jerome Powell described the U.S. labor market as being in “an unusual and uncomfortable kind of balance”³ with AI and war-related consequences to be determined, creating “two-sided” risks, with inflation risk at the forefront.
• What this means: This keeps interest rate uncertainty at high levels, making the requirement for interest rate hedging a critical focus. Changes in interest rates have a dramatic impact on liability valuations, especially given long-dated liabilities that magnify volatility even further. Sponsors should remain focused on hedging this risk with a tight hedge ratio, particularly with large, fixed income allocations that ease implementation. Forecasting interest rates has historically been difficult, and sponsors may want to avoid taking this uncompensated risk within their pension portfolios.

A closer look at the yield curve

• A steepening bias driven by higher-than expected inflation risk, the government potentially impacting Fed decision-making, and increased expected Treasury supply (driven by increasing budget deficits) puts upward pressure on term premia.
• The impact: Be careful of overweighting 30-year rate risk relative to liabilities (capital efficient duration) if the curve steepens—you may lose out. Plans with less fixed income often outweigh 30-year bonds to amplify their duration sensitivity (hedge ratio) in a capital efficient manner relative to their 8- to 12-year duration liabilities.

Reinforcing the importance of equities for diversification

• While equity allocations have been declining among pension plans (driven by higher pension-funded levels), the need for equities remains in many instances, albeit in smaller doses. This is supported by liability nuances and the need to maintain, or increase, funded status cushions.
• Compelling non-U.S. equity and currency valuations, and a potential rotation away from U.S. large cap leadership paints a landscape for continued non-U.S. outperformance versus U.S. equities, which have outperformed the U.S. since the start of 2025.
• Factors such as a strong dollar during geopolitical uncertainty, greater economic fallout abroad from conflicts, and shifting U.S. equity valuations may slow this process.
• Why it matters: A continued diversified approach to global equity exposure is warranted and reinforces the benefits of long-term diversification amid the ongoing market developments and challenges.