Consider Corporate Financials When Making DB Funding Decisions

DB plan sponsors making additional cash contributions to fund their plans should consider locking in those funding gains to reduce the amount of operating cash they allocate to their plans in the future.

Methods for reducing underfunded defined benefit (DB) plans should be looked at holistically, not in a vacuum, and they should be considered within a corporate financial context to avoid negative surprises to a company’s executive team, board of directors and shareholders, according to a white paper from Northern Trust Asset Management.

How DB Plans Got Here

Most corporate pensions have yet to recover to the funded levels they had before the 2008 financial crisis even though the market has done well because low interest rates have caused them to remain significantly underfunded. Northern Trust’s analysis of the 340 companies in the S&P 500 with pension obligations at the end of 2016 found the average asset value increased from $3.4 billion in 2008 to $4.9 billion in 2016 (44% growth).  However, in 2008 average liabilities were $4.3 billion and in 2016 liabilities were $6.1 billion (42% growth)—almost the same growth rate.

The reason for the growth in liabilities is partially due to participant accruals, but the primary cause is the drop in interest rates used to determine pension liabilities from 2008 to 2016 from 6.25% to 3.61%. Northern Trust explains that pension liabilities are determined by discounting expected benefit payments using the interest rate in effect, so as the interest rate drops, the liability climbs.

In 2012, the Moving Ahead for Progress in the 21st Century Act (MAP-21) changed the corridor of interest rates that could be used to calculate funded ratios. In 2014, the Highway and Transportation Funding Act (HATFA) extended provisions of MAP-21. And, finally, in 2015, the Bipartisan Budget Act further extended MAP-21 provisions, but it also increased Pension Benefit Guaranty Corporation (PGBC) premiums.

Segal Consulting Retirement Practice Leader Stewart Lawrence, based in New York City, says funding relief helped a little. “The first time it created a corridor, it did a lot of good for mitigating large increases in employer [contributions]. The second time was not as good but helped mitigate the volatility of contributions,” he explains.

According to Northern Trust, some DB plan sponsors have been waiting for higher interest rates to no avail. Dan Kutliroff, head of Solutions Strategy at Northern Trust Asset Management in Chicago, and co-author of the white paper, says, “We expect [interest rates] to rise slightly, but not to the point of helping underfunding.”

Increasing Contributions and the Effect on the Bottom Line

Since the 2008 financial crisis, many DB plan sponsors turned to liability-driven investing (LDI), which uses funded status triggers to change asset allocation to lock in funded status gains. More recently, plan sponsors have been putting more cash contributions into their plans to improve funding and to try to reduce PBGC premiums. Lawrence notes that some plans have even borrowed to increase pension contributions.

A 2016 survey from Prudential found 64% of DB plan sponsors reported either their companies had already increased contributions (15%) or that they were likely to do so within two years (49%). According to Northern Trust’s white paper, in 2016, the 340 companies it studied generated an average of just over $3.4 billion in cash from operating activities; however, they allocated $180 million of cash into their pension plans. That represented 5.3% of cash they generated from operating activities—a significant increase from 4.3% contributed to pension plans in 2015, as well as an increase from the relative 4.9% in 2014.

Northern Trust notes that over this three-year period, companies made significantly larger contributions than the cost of new accruals of their plans—47% greater cumulatively. While it believes the cash that companies generate will continue to grow, it thinks pension contributions will grow by a larger amount because funding relief has begun to wear away, new mortality tables increasing funding requirements are set for 2018, and companies are making discretionary contributions to minimize penalties such as PBGC premiums. “That money goes against building the business, acquisitions, paying shareholders, etcetera,” Kutliroff warns. “DB plan sponsors need to keep this in mind.”

On the positive side, notes Lawrence, if companies move cash from general assets to pension plans, it doesn’t affect their balance sheet in total, and it makes their plans better funded and lowers PBGC premiums. “It’s a real savings, all else being equal,” he says.

Kutliroff says if companies are putting more cash into pensions to improve funded status, they should be considering their investment strategy and possibly looking to use that cash to increase LDI to lock in the funded status gain from contributions. However, the white paper notes that there hasn’t been any positive movement in LDI over the last three years, indicating companies are still trying to earn their way out of their funding holes.

Earning Their Way out of Underfunding

“For organizations that don’t want to put in more contributions to their pensions than required, is their investment strategy aligned with that?” Kutliroff queries. “If not, they need to understand how not earning their way out of their deficits will impact corporate financials. How you invest and how you contribute or fund your pensions should be looked at in tandem.”

He notes that for many years, a lot of organizations’ pension strategy was driven by pension expense; many were reluctant to go down the LDI path because when they moved assets from equities to fixed income, it was expected to lower their expected return assumptions which increased expense. Interestingly, Northern Trust finds that over the last three years, operating earnings have decreased, but pension expense has decreased more than that. On a relative basis, pension expense has dropped from 5.4% to 4.8% over the last three years for the companies it studied.

“If these trends continue, and pension expense is lower, corporations may be willing to lower pension assumptions. The data shows organizations are more willing to lower their expected returns,” Kutliroff says. “I think it might be said in converse, if they move to LDI investing, it will lower their return assumptions, so if more are willing to lower return assumptions, more will be willing to move to LDI.”

Lawrence says there are two things DB plan sponsors do not like—large contribution requirements and volatility of contribution requirements. “When making an investment choice, they have to elect a trade-off. If they are more aggressive with investments and if the assets will perform, the plan is better funded and their funding requirement will go down; however, it increases volatility of contribution requirements,” he says. He contends DB plan sponsors are more focused on decreasing volatility of required contributions. “Plans generally used to be invested 40% in bonds and 60% in equities, now it’s more so a 50/50 stable allocation. They can handle higher required contributions, if they can pay for it.”

There are things an employer can control—contributions it decides to make to DB plans, the plan’s benefit formula, whether the plan is open or closed, investment policy—but an employer can’t control what assets and interest rates will actually do. “We tell employers they have to understand where the plan is heading financially. Do projections to get a picture of the future or the possible range of future outcomes. They may like the results at the end of step one, but if not, they can jiggle the things they can control,” he says. “They may say want to dampen volatility, and they can do that with investments. Changing investments may affect the profit and loss statement a little, but DB costs go down a lot. They can handle predictable costs not volatile costs.”