P/Es and Pension Funding Ratios

Abstract

Some evidence supports the intriguing conjecture that P/Es in the U.S. market may decline in times of both significantly lower, as well as significantly higher, real interest rates. The P/E response pattern would then resemble a tent that angles downward at both ends. For pension liabilities defined in real terms, very low real rates would then lead to a clifflike falloff in the funding ratio from the decline in equity valuations combined with surging liability costs. This article explores the risk implications of such a low-rate scenario and the equity valuations that could give rise to such a tent pattern.

Keywords: Portfolio Management, Asset/Liability Management, Equity Investments, Fundamental Analysis, Valuation Models