Breaking Free From Interest Rate Bind on DB Funding
Defined benefit (DB) plans are facing funding challenges, but there are actions that they can take to mitigate them.
The main problem is that the equity markets have been volatile and interest rates declined sharply in the late summer, says Gordon Young, senior director, retirement, at Willis Towers Watson in Milwaukee. Through the end of July, interest rates for both Treasury and high-quality corporate bond yields decreased to their lowest levels since the global financial crisis of 2008, Young notes. Then, in August, the 30-year Treasury yield dropped below 2% and the Merrill Lynch AA-AAA 10+ index dropped below 3%—both historically low levels.
Both public and corporate DB plan funding has suffered as a result. Goldman Sachs Asset Management estimates that the aggregate funded status of the U.S. corporate defined benefit (DB) system fell to 86% at the end of August, from 87% at the beginning of the year and a recent high of 91% in the second half of 2018. And while pension plans returned, on average, more than 15% through the end of August, actuarial losses due to the fall in interest rates reduced funded levels by a similar amount, says Mike Moran, senior pension strategist at Goldman Sachs Asset Management, based in New York.
Extrapolating forward rates from the current environment, Willis Towers Watson expects “rates will remain low for a while, and the yield curve might flatten even further,” Young says.
In addition, “with the aging population in the U.S. and around the world, this is causing an insatiable demand for fixed income,” which is pressuring interest rates, according to Moran. This is going to cause challenges for pension plans, he says.
“Of course, it depends on how well a plan is funded and the degree of liability hedging in the portfolio, but for most pension plan sponsors, lower interest rates are bad news,” Young says. “As interest rates continue to decrease, their liabilities are going to increase and they will face higher profit and loss and cash funding costs. For pensions that are open, the liabilities are greater because they are more exposed to volatility in the markets. For plans that are frozen and gradually shrinking their liabilities,” the exposure is less.
Mitigating funding challenges
The first thing a pension plan sponsor should do in this environment is to revise their forecast of costs to their plan, Young says. “Then they should reevaluate management policies that oversee their risks and costs, their settlement and valuation policies, to see whether or not they should change these in light of continued low interest rates.”
Goldman Sachs believes that plans with deficits “should earn their way out. Even though rates are low, we think they should continue to buy fixed income because they are under hedged,” Moran says. “Also, in an environment where many asset classes are at high levels, they should diversify their portfolios into alternative, non-core fixed income, hedge funds and liquid alternatives that are more defensive. We view rebalancing to your appropriate strategic targets as a prudent risk management exercise. Whether it is done quarterly, monthly or when there is a deviation from your targets doesn’t matter as long as you do something.”
DB plan sponsors will inevitably also have to increase their contributions, Moran adds. “On the corporate DB side, many plans have enjoyed funding relief from Congress, enabling them to contribute less than they otherwise would have had to,” he notes. “Many of these rules sunset in 2021, and if interest rates are still low then, their contributions will need to go up.”
Pension plans can also better manage their Pension Benefit Guaranty Corporation (PBGC) premiums, Moran says. “There are two such premiums: a flat rate based on the number of participants in their plan and a variable rate of 4.3% based on a plan’s deficit,” he says. “With interest rates going down, the cost to borrow is below that 4.3%. Plans could use that money to pay the premium. That is effective arbitrage. Caterpillar, UPS and FedEx have done this, and we expect more plans to do the same.
“And on the flat rate side, we see a number of organizations looking for ways to get out of the plan through a lump-sum payment to participants or by buying an annuity through an insurance company,” Moran continues. “In fact, many large-scale organizations, including FedEx and Bristol Meyers have done just that.”
Finally, Moran says, interest rate impacts don’t “hit” plans until their measurement date: “In other words, for a company that operates on a calendar year basis, any adjustment to the discount rate from the fall in interest rates would not occur until the end of December of this year, [meaning that] any balance sheet adjustment due to a change in funded status would not occur until that time, and any potential increase in recognized pension expense from an increase in the projected benefit obligation would not occur until 2020.”
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