DB Plan Funding Takes a Hit From Record-Setting Low Interest Rates in August

Pension plans that have invested in long bonds would have benefited, according to Northern Trust Asset Management, and Legal and General Investment Management America suggests market volatility can be risk-managed and controlled to a specific target with the use of an overlay.

The estimated aggregate funding level of defined benefit (DB) pension plans sponsored by S&P 1500 companies decreased by 4% in August 2019 to 82%, as a result of a decrease in discount rates and equity markets, according to Mercer.

As of August 31, the estimated aggregate deficit of $451 billion increased by $129 billion as compared to $322 billion measured at the end of July.

The S&P 500 index decreased 1.81% and the MSCI EAFE index decreased 2.88% in August. Typical discount rates for pension plans as measured by the Mercer Yield Curve decreased from 3.38% to 2.95%.

“Funded status dropped sharply in August with interest rates now at their lowest point in modern history,” says Matt McDaniel, a partner in Mercer’s Wealth business. “Interest rates decreased dramatically during August with the 30-Year Treasury falling to an all-time low at under 2%. The yield curve inverted, which has historically signaled an impending recession, and equity returns for August were negative as well.”

According to McDaniel, “Plan sponsors who banked recent gains and de-risked effectively are now in a much better position for having done so. The current environment leaves us with a puzzling dilemma: where to invest when most asset classes look expensive. With historically low interest rates and a potential market correction on the horizon, it’s more important than ever for plan sponsors to evaluate their risk management plans and adjust as necessary.”

Legal and General Investment Management America (LGIMA) suggests while sponsors are certainly focused on expected return, a significant driver of allocation decisions is based upon expected volatility. However, plans often realize a much different level of volatility than originally expected. Market volatility can be risk-managed and controlled to a specific target with the use of an overlay.

LGIMA estimates that the average plan’s funding ratio fell 5.4% to 76.9% through August. The Treasury component decreased by 55 basis points while the credit component widened 13 basis points, resulting in a net decrease of 42 basis points. Overall, liabilities for the average plan increased 6.67%, while plan assets with a traditional “60/40” asset allocation decreased by approximately 0.36%.

According to Wilshire Consulting, the aggregate funded ratio for U.S. corporate pension plans decreased by 3.8 percentage points to end the month of August at 81.3%.

It says the monthly change in funding resulted from a 7% increase in liability values partially offset by a 2.1% increase in asset values. The aggregate funded ratio is estimated to be down 6.2 and 11.4 percentage points year-to-date and over the trailing twelve-months, respectively.   

“August’s decrease in funded ratio was driven by the perfect storm of economic forces for corporate pension plans: falling discount rates and negative equity returns,” says Ned McGuire, managing director and a member of the Investment Management & Research Group of Wilshire Consulting.  “August’s 3.8 percentage point decrease in funded ratio is the second largest monthly decrease this year and fourth monthly decrease in 2019.”

The funded status for DB plans that were not hedged likely decreased significantly for the month, according to River and Mercantile’s September Retirement Update.

It says discount rates plummeted in August, dropping 0.44%. Current rates are now down 1.22% since year end 2018 and are 1.07% lower than rates from this time last year. The FTSE pension discount index finished August at 3%. Global equity markets were down, while bond markets rallied due to the flight to safety. On August 14, the yield curve inverted and equity markets experienced the worst trading day so far this year. In the month, emerging markets were hit the hardest, falling 4.9%, while the U.S. and international developed markets trailed by 2% and 2.6%, respectively.

Both model plans that October Three tracks lost ground last month, ending August at the low point for the year. Plan A lost more than 5% last month and is now down almost 7% for the year, while Plan B lost more than 1% and is now down 1% through the first eight months of 2019. Plan A is a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, while Plan B is a largely retired plan (duration 9 at 5.5%) with a 20/80 allocation with a greater emphasis on corporate and long-duration bonds.

Brian Donohue, partner at October Three Consulting, says corporate bond yields hit new all-time lows during the month. “Pension liabilities increased 4% to 6% in August and are now up an astounding 15% to 25% for the year, with long duration plans seeing the largest increases.”

Looking to the future, Donohue says, “Pension funding relief has reduced required plan funding since 2012, but under current law, this relief will gradually sunset. Given the current level of market interest rates, it is possible that relief reduces the funding burden through 2028, but the rates used to measure liabilities will move significantly lower over the next few years, increasing funding requirements for pension sponsors that have only made required contributions.”

According to Northern Trust Asset Management (NTAM), the average funded ratio of corporate pension plans declined in August from 86% to 82.5%. It also says both negative returns in the equity market along with higher liabilities led to lower funded ratio. According to NTAM, global equity market returns were down approximately 2.4% during the month, and the average discount rate decreased from 2.99% to 2.56% during the month.

Jessica Hart, head of OCIO Retirement Practice, notes, “Recession fears have escalated as the yield curve inverted and trade tensions escalated. Pension plans that have invested in long bonds would have benefited from its favorable performance as rates at the long end of the curve have declined.”