Tag Archives: discount rates

PPA segment rates: Looking ahead

Kliternick-StuartBack in April, I had discussed that the process used to determine the Pension Protection Act (PPA) segment rates under the Highway and Transportation Funding Act of 2014 (HATFA) was so stable that one could predict the segment rates to be used in the next several years with strong accuracy. Using 5,000 stochastic simulations of the yield curve, assuming funding laws in effect at that time and based on Milliman’s capital market assumptions and published surveys of interest rate forecasts by economists, it appeared that the 2016 PPA segment rates were all but finalized. Those predicted segment rates match what the PPA segment rates will be in 2016: 4.43%, 5.91%, and 6.65%.

Since then, the Bipartisan Budget Act of 2015 (BBA) was signed into law on November 2. BBA extended the current corridor used as the floor and ceiling for PPA rates. The range of 90% to 110% was extended for three years through 2020, when the corridor will widen annually by 5 basis points on both sides until it reaches a range of 70% to 130% for the 2024 plan year and beyond. In addition, BBA also provided the Pension Benefit Guaranty Corporation (PBGC) flat-rate premium and the variable-rate premium percentage to be used for the next several years (subject to indexing).

In order to account for these changes, we have updated our segment rates projections for the next several years. The first table below projects for 2016 to 2019, showing the 50th percentile of the 24-month average rates (assuming a calendar-year plan with no look-back period), and a range using the 5th and 95th percentile rates as endpoints for 2016 to 2019.

Year 2016 2017 2018 2019
First Segment Rate 1.41% (1.31% – 1.53%) 1.80% (0.93% – 2.92%) 2.25% (0.48% – 4.70%) 2.66% (0.30% – 5.88%)
Second Segment Rate 3.96% (3.88% – 4.05%) 4.13% (3.40% – 4.96%) 4.49% (2.95% – 6.28%) 4.70% (2.71% – 7.14%)
Third Segment Rate 4.99% (4.92% – 5.07%) 5.16% (4.49% – 5.86%) 5.51% (4.18% – 6.96%) 5.68% (4.01% – 7.52%)

As the table indicates, interest rates are expected to rise over the next several years. Short-term rates are projected to rise by as much as 125 basis points, while mid-term and long-term rates are projected to rise by about 70 basis points.

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Milliman infographic: Pension liabilities

When the discount rate increases the projected benefit obligation (PBO), or pension liability, decreases, and vice versa. This relationship explains the volatile nature of pension liabilities and demonstrates why liabilities-driven investment strategies, which manage funded status and limit volatility of pension liabilities and asset returns, are useful.

PFI-graphic_final-screenRes_600x

To read the entire Corporate Pension Funding Study, click here.

Projected funding rates for the next several plan years

Kliternick-StuartThe assumptions actuaries use to calculate funding and accounting liabilities for defined benefit (DB) plans are in the process of undergoing revisions over the next several years. The Society of Actuaries recently released new mortality and mortality projection tables and, even though the Internal Revenue Service has yet to adopt the new mortality tables for funding purposes, several plans are using either these tables or a modification of the current standard tables when calculating their accounting disclosure liabilities. Actuarial Standards of Practice (ASOPs) will encourage actuaries to review other demographic assumptions (e.g., withdrawal) and economic assumptions, such as the consumer price index (CPI). And, as the Milliman Pension Funding Study shows, the discount rates used for accounting purposes have fluctuated.

However, because of recent law changes made by the Moving Ahead for Progress in the 21st Century Act (MAP-21) and the Highway and Transportation Funding Act of 2014 (HATFA), pension funding discount rates for plans that use segmented interest rates have been relatively stable for the past several years. In fact, the process used to determine the segment rates under HATFA is so stable that, absent additional funding rules changes, one can predict with reasonable accuracy the segment rates to be used for funding valuations for the next several plan years.

As an example of the stability of the process for calculating the HATFA rates, assume that the yield curve used to calculate the segment rates remains constant from February 2015 (the most recent yield curve released as of this blog post) through September 2015. The calculated rates used to establish the HATFA corridor would be 4.92%, 6.57%, and 7.39%. The low-end segment rates of the HATFA corridor, which make up 90% of those rates, are 4.43%, 5.91%, and 6.65%. They would be the rates used for 2016 plan year valuations. These rates do not change even if the yield curve used to calculate the segment rates were to increase by 42 basis points each month through September 2015 or decrease by 19 basis points each month.

We have calculated 5,000 stochastic simulations of the Pension Protection Act of 2006 (PPA) yield curve, assuming current funding laws remain in place throughout this calculation and using Milliman’s capital market assumptions. The table below shows the results for the next four years showing the 50th percentile of the 24-month average rates (assuming a calendar-year plan with no look back period), and a range using the 5th and 95th percentile rates as endpoints for 2015-2018.

Year 2015 2016 2017 2018
First Segment Rate 1.22% 1.48%(0.94%-2.11%) 1.89%(0.46%-3.71%) 2.30%(0.16%-5.11%)
Second Segment Rate 4.11% 3.94%(3.49%-4.42%) 4.04%(2.81%-5.37%) 4.36%(2.55%-6.50%)
Third Segment Rate 5.20% 4.96%(4.56%-5.37%) 5.04%(3.98%-6.17%) 5.40%(3.86%-7.08%)

As the table indicates, short term interest rates are projected to rise over the next several years, perhaps as much as over 100 basis points. Mid-term and long term rates are projected to initially fall and then rise about 20 to 25 basis points over the next several years. As such, the effective interest rate on this basis would rise by about 25 basis points depending on the plan’s payout streams.

Next, the following chart provides the 50th percentile of the stochastic simulations of the low end of the HATFA rates through the 2018 plan year, and a range using the 5th and 95th percentile rates as endpoints for each segment for 2015-2018. As a reminder, the segment rate to use when calculating liabilities is the greater of the 24-month average rate and the low-end HATFA corridor rate. Therefore, if the HATFA rate is lower than the 24-month average rate, the 24-month average rate will be used in the stochastic simulation.

Year 2015 2016 2017 2018
First Segment Rate 4.72% 4.43%(4.43%-4.44%) 4.16%(4.13%-4.19%) 3.71%(3.63%-5.10%)
Second Segment Rate 6.11% 5.91%(5.91%-5.91%) 5.72%(5.70%-5.74%) 5.23%(5.16%-6.50%)
Third Segment Rate 6.81% 6.65%(6.65%-6.65%) 6.48%(6.46%-6.50%) 5.96%(5.90%-7.08%)

As this table indicates, despite the rise in the 24-month average rates, the HATFA rates drop by 85 to 101 basis points. This would cause a typical plan’s effective interest rate for funding purposes to drop by 84 basis points from 2015 to 2018, which leads to an increase in the Target Liability by over 10.5%. The large drop in the HATFA rates from 2017 to 2018 is due to two reasons: the HATFA corridor widens by 5% starting in 2018 so the low end of the corridor is now 85% of the 25-year average used to calculate the HATFA rates; and the highest rates in the 25-year average used to calculate the HATFA rates are removed by 2018.

Based on the stochastic simulations, it would appear that the 2016 plan year HATFA segment rates have already been determined. The 5th to 95th percentile interval around the midpoint rate is the same except for an increase of one basis point in the first segment, and the 24-month average rates do not approach the HATFA rates. In addition, it can reasonably be predicted that the 2017 rates will be the HATFA rates based on these simulations. This is due to the 24-month average rates in the first table not approaching the HATFA corridor rates in the second table. Because the 5th to 95th percentile interval around each projected 2017 plan year HATFA rate is narrow, using the midpoint rates in projecting 2017 liabilities will result in a good estimate of the 2017 liability to be used for minimum funding purposes.

However, for 2018 the 5th to 95th percentile interval around the midpoint HATFA rate widens, especially going from the 50th percentile to the 95th percentile. This increase is due to the projected 24-month average being greater than the low-end HATFA corridor rate. The likelihood of the 24-month average rate falling inside the HATFA corridor increases in the next several plan years as the HATFA corridor widens to 70% to 130% of the 25-year average. Therefore it becomes harder trying to predict plan year segment rates starting in 2018.

The evolution of the discount rate for measuring employee benefit obligations under AS15(R)

This paper by Milliman consultants Danny Quant and Simon Herborn provides an update for the quarter ended June 30, 2014, on discount rate changes as they apply to liabilities under AS15(R), India’s accounting standard for the cost of providing employee benefits. Implied yields have fallen since March 31, 2014. The impact of this fall will depend on the weighted average expected future working lifetime (WAEFWL) of employees.

HATFA-14 and discount rates: The latest in “pension smoothing” provisions

Yu-LynnOn July 15, 2014, the U.S. House of Representatives voted 367-55 to approve H.R.5021, the Highway and Transportation Funding Act (HATFA-14), which provides funding for the Highway Trust Fund on a short-term basis (through May 2015). HATFA-14 also includes an extension of the “pension smoothing” provisions that had been adopted in the Moving Ahead for Progress in the 21st Century (MAP-21) Act. The bill would extend the MAP-21 funding stabilization provisions for five years (through 2020).

MAP-21 was enacted in July 2012. MAP-21 uses a 25-year average of a bond yield curve, which produces significantly higher rates than the 24-month average used before MAP-21. MAP-21 then imposes the minimum and maximum rate using a 10% corridor around these average rates. The corridor for determining the minimum and maximum rate expands 5% each year, ultimately reaching 30% by 2016.

HATFA-14 revises the minimum and maximum percentage ranges for a plan year as follows:

• 90% to 110% for 2012 through 2017
• 85% to 115% for 2018
• 80% to 120% for 2019
• 75% to 125% for 2020
• 70% to 130% for 2021 or later

The proposals relating to the applicable minimum and maximum rates are generally effective for plan years beginning after December 31, 2012. Under a special rule, an employer may elect, for any plan year beginning before January 1, 2014, not to have these proposals apply either (1) for all purposes for which the proposals would otherwise apply, or (2) solely for purposes of determining the plan’s adjusted funding target attainment percentage in applying the benefit restrictions for that year. A plan will not be treated as failing to meet the requirements of the anti-cutback rules solely by reason of an election under the special rule. By electing out in 2013, plans that have already prepared the 2013 Form 5500 will not be disrupted.

This is great news for plan sponsors who have short-term cash flow issues. Even though the Pension Benefit Guaranty Corporation (PBGC) variable rate premium calculation does not use rates under HATFA-14 relief, there was no PBGC premium increase in this bill, unlike MAP-21. Upon HATFA-14 being enacted, our first course of action will be to revisit 2013 plan year valuations. This should make for more exciting times in the world of pension funding!

Discount rates up, but beware of potential funding issues

Kliternick,-Stuart_mugShotCurrent discount rate yield curves have increased by approximately 80 basis points since the December 2012 yield curves. For plans that have to disclose their pension plan liabilities under FASB ASC Subtopic 715-20 at the end of the year, that is great news. Assuming a plan not weighted toward active or retired participants, December 31, 2013, disclosure liabilities will be lower than in 2012 by about 8% to 9%. Combined with asset gains, plans should see a significant increase in their funded status. The December 2013 Milliman 100 Pension Funding Index shows an improvement of 16.7% on funded status from December 31, 2012, with a little more than half of that improvement attributable to the rise in discount rate.

However, this may not be true when it comes to the calculation of the cash contributions, done separately under rules from the IRS, and which are referred to as the funding side. The 2014 segment rates will be 4.43%, 5.62%, and 6.22%. This represents a drop in each segment of more than 50 basis points from the 2013 MAP-21 rates of 4.94%, 6.15%, and 6.76%, respectively. Assuming a plan with intermediate duration as described above, this corresponds to an increase in liabilities that is solely due to the change in segment rates of approximately 6%.

There are two reasons for this drop in segment rates: (1) a widening of the corridor used as a minimum to determine the segment rates from 85%/115% of the 25-year average segment rate in 2013 to 80%/120% in 2014; and (2) the 25-year average of segment rates used to calculate the MAP-21 corridor replaces high historical rates with significantly lower current rates.

Moreover, because both the corridor will widen again in 2015 (to 75%/125% of the 25-year average), and low rates will be replacing high rates when calculating the 25-year average, this trend will continue for 2015 valuations. Assuming a constant yield curve from the November 2013 Pension Protection Act (PPA) yield curve, the 2015 low-end MAP-21 corridor rates would be 3.93%, 5.09%, and 5.68%. Because the segment rates prior to MAP-21 would not be higher than these rates, they would be the rates for 2015 valuations. In fact, they would be the segment rates for 2015 valuations (with maybe a movement of 1 basis point) if every segment of the PPA yield curve were to increase or decrease by 10 basis points every month for the next 10 months.

So despite the improvement on the accounting side, pension plans may not see much of an improvement on the funding side in 2014 results from 2013. And depending on if assets can keep up the gains over the past two years, pension plans may be in a position where they will be approaching 100% funded status on an accounting basis but still require a significant level of contributions on a funding basis in 2015. While plan sponsors may want to celebrate the good news on the accounting side, now is the time to work on a plan to help the funding side for the next couple of years.