Now that the presidential election is behind us, much of the political uncertainty that existed prior to the election has subsided, but uncertainty about the investment markets remains high. Interest rates spiked upward after the election and have continued moving higher. U.S. equity prices also spiked upward and have continued climbing. Now that we’re into December, plan sponsors are trying to gauge the impact of these recent events on end-of-year pension plan assets and liabilities. The longer-term impact of the Trump victory, however, is more difficult to predict.
President-elect Trump’s plans for corporate tax cuts, infrastructure spending, and deregulation are cited as some of the factors driving interest rates and expected inflation higher. The yield on the 10-year U.S. Treasury bond has increased about 50 basis points (0.50%) since the election, while the yield on the 10-year U.S. Treasury Inflation-Protected (TIP) bond has increased about 30 basis points (0.30%). The difference between the two yields, known as “breakeven inflation,” is a measure of inflation expectations. By this measure, expected average inflation over the next 10 years has increased by about 20 basis points (0.20%) since the election.
High-quality corporate bond yields—the basis for pension discount rates for accounting disclosure purposes—have increased by about 35 basis points (0.35%) since the election. If these yields remain at this level through the end of the year, plan sponsors could benefit from a drop of several percentage points in the value of their pension obligations (since the election), although yields are still below where they were at year-end 2015.
The Federal Open Market Committee (FOMC) is widely expected to raise its federal funds target interest rate when it meets this week. This would be the first increase since December 2015. It’s too early to predict whether this will be a single increase or the first of many increases over the next couple of years. If the Fed raises its target rate several more times, this could help support the recent spike in longer rates and possibly contribute to additional increases.
It’s easy to understand why pension participants get confused looking through their annual plan funding notices. The notice presents several different measures of the plan’s funded status and provides details for multiple measurements at different points in time. In a new article entitled “Funded status measurements for U.S. pensions,” Zorast Wadia explains these types of measurements.
The article was written as an introductory piece for an international audience, providing perspective on funded status measurements under U.S. Internal Revenue Service (IRS) pension funding rules.
Here is an excerpt:
Funded status measurements
Several funding status measurements can possibly be derived from reading an annual funding notice. Each of the following funded status measurements involves comparing a plan’s asset measure to its liability measure, and often the comparison is made with and without respect to the inclusion of credit balances. Exactly which components are used within a particular funded status measurement is quite important. The various permutations on funded status measurements that exist can make this subject a little complicated and somewhat burdensome to explain to the non-pension practitioner.
Measurement Number 1: Actuarial value of assets compared to the funding target
These results appear on the first page of the funding notice and are shown for the last three years. If a plan’s actuarial value of assets is greater than or equal to a plan’s target liability, the plan is generally considered well funded and free of potential benefit restrictions. Depending on their nature, benefit restrictions may limit distribution options, benefit improvements or benefit accruals. If a plan’s actuarial value of assets is less than the target liability, then things start to get a little more complicated and this often leads to a more refined measure of the plan’s funded status.
Measurement Number 2: Actuarial value of assets reduced by the credit balances compared to the funding target
This funded status measurement is shown on the funding notice and often results in a highly skewed funding measure, depending on the size of a plan’s total credit balance. A plan may only be slightly underfunded when comparing just the actuarial value of assets with the target liability, but may be greatly underfunded when one subtracts credit balances from the asset value. This key measurement often determines whether a plan faces benefit restrictions. This measure may also determine whether a plan will need to make minimum funding contributions on an accelerated basis in the following year. Lastly, it can also have a great impact on the calculation of the amortization cost or credit component of the minimum funding requirement.
Without Congressional action by December 31, a series of tax cuts will expire, and automatic spending cuts will kick in. After a contentious election, the big question now is: Will the debt discussion be different this time? Will there be more political brinkmanship or has the tone shifted enough to allow for bipartisan cooperation? More importantly for our readers here: What will the outcome of the fiscal cliff negotiations mean for retirement plans if the fiscal cliff isn’t addressed before December 31?
The first day after the election, the Dow lost over 300 points, its largest one day loss in over a year. During the deliberations to raise the debt ceiling, the stock market was extremely volatile. With this backdrop, more stock market volatility is entirely possible. If we experience a drop in the stock market between now and December 31, the asset values for all retirement plans will be down. This will affect savings plans, IRAs, and pension plans.
Milliman’s November 2012 Pension Funding Index showed a pension funding deficit of $498 billion. If the fiscal cliff is not addressed in a timely manner, this deficit could get worse. In order to illustrate the possible implications for pension plans, we used the latest Milliman Pension Funding Index and assumed an equity decline of 20% in December. If such a scenario plays out it will lead to a record low in pension funded status.
Unless interest rates rise, corporate pension plan sponsors who measure their liabilities based on the current level of interest rates will continue to use historically low interest rates. This means their plan liabilities will remain at high levels, a hit to the corporate balance sheet, which is due to the pension plan’s funded status and an increase in contributions for the 2013 plan year.
For public pension plan sponsors, this will likely mean higher contribution rates for the 2013 plan year. For those pension plan sponsors who do not measure their assets and liabilities on December 31, it’s a matter of wait and see what happens until they check in next.
When Moving Ahead for Progress in the 21st Century (MAP-21) was passed, the interest rate stabilization provisions provided much needed funding relief for defined benefit pension plan sponsors. However, taking full immediate advantage of the reduced minimum funding requirements may not be the best answer for all sponsors, for a couple reasons.
First, the stabilization provisions have a significant impact in the short term, but that impact diminishes in the long term. Under the scenario where current interest rates remain at or near historically low levels, minimum funding requirements are projected to ramp up every year. Pension funding rules provide some flexibility such that smoothing out contributions over, say, a five-year period could be an appealing option in order to reduce contribution volatility.
Second, Pension Benefit Guaranty Corporation (PBGC) premiums will increase dramatically over the next few years. Currently, the variable rate premium (one component of the premium) is equal to 0.9% of the pension plan’s unfunded obligation. By 2015, that percentage will double to 1.8%. The same strategy of smoothing out contributions over a time period such as five years could translate into sizeable PBGC premium savings over that period. For example, the 2015 premium would be $18,000 lower for each $1,000,000 that the plan’s assets are higher under the smoothing strategy versus the bare minimum strategy. The same is true for the remaining years in the smoothing period.
Defined benefit pension plan funding relief may be just what some companies need right now in an uncertain economy. But others should take this opportunity to project funding requirements over the next several years, and perhaps find a strategy that will both reduce volatility and result in real cash savings through lower PBGC premiums.
It’s no secret that rock-bottom interest rates and slumping assets are severely limiting the ability of underfunded pensions to bounce back from a horrific third quarter in 2011. As we move into 2012 we wondered what you think the next year has in store for pensions. So we’re asking: