In the pre-PPA period, plan sponsors enjoyed a period of contribution stability along with the flexibility to utilize “credit balances” built up from prior contributions. With the PPA now in place, plan sponsors have witnessed severe contribution volatility. They also have seen restrictions on the usage of credit balances, and on benefit distributions and accruals. On top of this, PPA guidelines have compelled them to provide increased disclosures to participants of the funded status of the plan.
Pre-PPA – The calm before the storm
Prior to the implementation of PPA, most sponsors of qualified retirement plans would utilize a long-term investment strategy with a policy of earning 7.5% or 8.0% per year. That rate would determine how they valued the liabilities of the associated plan.
Pre-PPA, most plan sponsors also utilized an asset smoothing method. This would allow the actuarial valuation of plan assets to differ by up to 20% from the market value of plan assets with the 80%/120% corridor allowed under Internal Revenue Service (IRS) rules. This permitted the plan sponsor to minimize year-to-year asset volatility, thus ensuring any losses would be relatively modest.
PPA – A perfect storm of lower interest rates, the financial crisis and contribution volatility
With PPA implemented, plan sponsors were faced with an entirely new landscape of liability valuation strategy, participant disclosures and a reduction in asset smoothing options.
PPA was designed with many targeted purposes. One was a stronger plan-funding scheme to increase benefit security. The intention of this was to limit the risk of potential losses backed by the Pension Benefit Guaranty Corporation (PBGC). PPA also set out to provide more useful disclosures to plan participants of the financial health of their plans.
This was to be accomplished through the use of a “mark to market” approach on plan liabilities utilizing the yield curve of high-grade (“AA” rated) corporate bonds rather than the prior long-term methodology of discounting all liabilities at one rate (i.e., 7.5% or 8.0%).
PPA was passed in 2006 and went into effect in 2008, however Congress did not see the financial crisis coming. It brought with it the problematic combination of much lower interest rates (thus increasing plan liabilities) and a large drop in equity prices. This inevitably served to greatly increase unfunded plan liabilities, which were now to be funded over a shorter period.
PPA – 2008 to today
Over the last several years, Congress has passed several patchwork “fixes” including the most recent Moving Ahead for Progress in the 21st Century (MAP-21) Act. They are only treating the symptoms rather than the underlying causes and issues.
While plan assets may have performed very well (i.e., 10% or higher returns for a year), plan liabilities may have increased by even more. This can be attributed to either a reduction in discount rates or a shift in the shape of the yield curve from year to year.
In the era prior to PPA, treating plan assets and liabilities as independent silos may have been a stable enough strategy. With PPA now in place, however, such an approach is likely to result in wide swings in the funded status of the plan.
Under PPA, plan liabilities are valued as a fixed income investment. Ultimately, this valuation reflects that they will serve as a stream of predictable payments in the future. As such, in order to stabilize unfunded plan liabilities and minimize contribution volatility, plan sponsors should look at matching their assets to that underlying stream of payments.
A traditional LDI approach would utilize a 100% fixed income portfolio that matches all expected payments from the plan to a laddered set of investments. Under this approach, assets and liabilities are expected to have comparable changes in value as the yield curve changes.
This allows the plan sponsor to remove changes in asset values and the yield curve from the equation. Actuarial gains or losses are only based on plan demographic and are usually very small. This will yield much lower contribution volatility, but often from a higher contribution amount as equities are removed from the portfolio.
Modified LDIUnder a modified LDI approach, the plan sponsor would seek to match plan asset income to the expected payment stream for the first six to 10 years and may use dividend-paying stocks as part of that match.This allows the plan sponsor to maintain a comparable beta of plan assets and plan liabilities while still allowing them to seek alpha returns from their long-term equity component.
Given that long-term equity performance is expected to be positive and that fixed income rates are at historic lows, this would lead to much lower contribution volatility but also a lower total contribution than would be expected from a traditional LDI approach.
As of September 2013, the funded status of qualified defined benefit pension plans has increased to 88%, per a study from Aon Hewitt.
We’ve survived the crisis and plans have gotten back to reasonable funding levels. Now is the time to buy stability so as to avoid going backwards.
Your actuary and investment professional can work to develop an LDI approach that meets your needs. This will allow you to maintain reasonable plan funding and to plan your cash flow budget better. It will also minimize negative reaction on participant disclosures. And lastly, it will improve pension disclosures under FASB 87/158.
Parker Elmore, President of Odyssey Advisors
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.