DB Plans Can Expect Continued Funded Status Issues

The solutions to manage funded status differ for public and corporate plans.

Though the market has rebounded from its low point in the first quarter, investors are probably not out of the woods yet, says Cooper Abbott, president and chairman of Carillon Tower Advisers. He points to the market drops that happened in just the past week, saying, “I’m not sure we’re done.”

And the recent Fed announcement regarding lower interest rates for longer will have a significant impact on defined benefit (DB) plan sponsors, says Tom Swain, a principal at Findley. He says the latest funded status tracking is showing that private-sector DB plans’ funded status overall dropped approximately 9% since March. He points out that while that is significant, it is much milder than during the Great Recession of 2008-09 when funded statuses dropped 25% to 30%.

Low interest rates are having the same effect on public plans as corporate plans, Abbott says. The math is basically the same.

Abbott also says it’s important to consider the challenges in the real economy—tax receipts are down, state taxes are down, corporate taxes are down and real income is down. “It’s not going to get better any time soon. Even gas tax receipts are a big part of state government funding,” he says. “So funding status is going to be a problem for a long time.”

At a high level, the difference between government and corporate DB plans is that there is a “full faith and credit” backing government plans, so benefits will get paid one way or another, Abbott says, noting that taxpayers are on the hook. For corporate DB plans, corporations may go bankrupt. Abbott says mergers can help reduce firms’ pension obligations.

According to Swain, with interest rates—and plan funded status—so low, corporate plan sponsors are having to hold off on moves to offload risk by doing a pension risk transfer. He says this bears out in data. LIMRA reports about a 25% drop in dollar volume of annuity purchases from a year ago.

“Volatility is a day-by-day thing, so there’s no way to predict for calendar year plans where the market will line up by December 31,” Swain says.

Abbott notes that there is what he calls an “early retirement boomlet” in both the public and private sectors. Some individuals have things to deal with in their personal lives that make them decide to retire; some are close to retirement age and have decided to lock it in now since the market has recovered. In the public sphere, public safety workers and educators are retiring earlier than they initially planned. “The reality isn’t matching public plan assumptions of when things need to happen, and these plans are losing big contributors,” Abbott notes.

Actions Public DB Plan Sponsors Should Consider

“When you look broadly at the funded status for public pensions, it’s really a tale of two cities or states,” Abbott says. “Some are doing great, while some are in dire straits and will require adjustments.” He says the major levers are assets and liabilities. On the asset side, public pensions might have over-relied on returns and haven’t included enough funding. Plan sponsors should ask, “Do we have enough assets and are they well invested? Have we contributed enough?”

For public-sector DB plans, the pandemic has had much milder effects than in 2008-09, Swain says. He adds that most public plans have fiscal year ends of June 30. The markets had stated to rebound by then so even though required contribution levels were slightly higher, it was not as bad as public plan sponsors had feared at the end of March.

Swain says the general trend for private-sector plans is that, with every recession, more plan sponsors have decided to close their plans to new members or freeze their plans. There are many more open and accruing plans in the public sector.

He adds that contribution effects unfold more slowly for public-sector plans, but he is still anticipating conversations about amending plans to create new plan designs that might include participant choice and closing plans with current participants grandfathered in. “We expect public plan sponsors to pull all levers, including changing benefits and requiring additional contributions from members,” Swain says.

It’s the liability side of the equation that Abbott thinks doesn’t get enough attention. “For public plans, the amounts anticipated to be paid include amounts related to health care and longevity. To try to have better outcomes on the liability side, focus on wellness rather than sick pay,” he says.

While there is no magic bullet, Abbott says, plan sponsors can help people focus on staying healthy and consider implementing later retirement ages in plans going forward for people entering the system. Another possibility is resetting the amount of coverage, winding back some benefits.

“A number of plans have gotten it right,” Abbott says, citing a PLANSPONSOR article about what well-funded public plans are doing. “Public plans also need a long-term strategy and to not take on risk to make up for funding gaps,” he adds. “It will take a re-evaluation of portfolios to be more return oriented. I’ve seen an interest in active management for returns and also to protect portfolios on the downside.”

Actions Corporate DB Plan Sponsors Should Consider

Abbott says corporate DB plan sponsors have more flexibility in what they can contribute to plans. He says they should ask whether contributions go to share buybacks or to shore up their plans.

“We’ve completed most of our 2020 actuarial valuations for calendar year plan sponsors,” Swain says. “Because 2019 was such a strong year, required contribution levels are lower than in 2019. This is a good thing because a lot of plan sponsors are suffering economically.”

Plan sponsors should first start with assessing how their businesses are doing. “We know certain industries have been deeply affected by the pandemic, so we are having conversations about what CARES [Coronavirus Aid, Relief and Economic Security] Act provisions they can execute to defer contributions,” Swain says. Plan sponsors need to determine whether it makes more financial sense for them to defer required minimum contributions.

For clients in industries not as deeply affected by the pandemic, Swain says he’s advised that they continue to make their required contributions so they can continue to invest in the markets and keep plans funded as much as possible. Even plan sponsors that are doing well are concerned about what the future holds, so no one has talked about contributing more than the required amount this year, he adds. They are conserving cash for their businesses.

While contributions are going to ratchet up funded status for corporate plans, Abbott notes that it is clear these are unprecedented times. “Fixed income has been such a large equation in corporate DB plan portfolios. What does fixed income look like in a world where there’s no income?” he queries. He says duration is the consideration in an environment where rates can go even lower. “At some point, rates will have to go back up, so DB plan sponsors should have a strategy that is unconstrained and free from benchmarks so they can take advantage of tactical moves,” Abbott adds.

He says he has seen a move to equities in corporation pension portfolios, including to large caps that have a dividend component.

“The other thing we’ve heard from clients is about the concept of inflation. Most asset managers today haven’t really managed through that environment, so maybe commodities and/or precious metals will become part of the equation,” Abbott says.