Barry’s Pickings: Extend HATFA Now

Michael Barry, president of O3 Plan Advisory Services LLC, discusses how interest rate “stabilization” is still needed in this era of sustained low interest rates and suggests improvements to the process.

Art by Joe Ciardiello

Art by Joe Ciardiello

Medium- and long-term interest rates have declined 75-100 basis points since the beginning of the year. For a typical pension plan, that decline will increase liabilities by close to 20%. That increase may, for funding purposes, be partly or wholly offset by asset gains for many plans (stocks have also gained 20% so far this year).

There are reports that some policymakers are considering an extension of the interest rate “stabilization” rules under the Highway and Transportation Funding Act (HATFA). Currently, under HATFA, liability valuation interest rates are determined using 90% of a trailing 25-year average of rates. As a result, Employee Retirement Income Security Act (ERISA) minimum funding valuation rates are nearly 200 basis points higher than (current) market rates.

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During the period from 2021 to 2024, HATFA rates will (per the statute) be reduced to 85% of the 25-year average (in 2021), 80% (in 2022), 75% (in 2023), and finally 70% (in 2024), in effect jacking up liability valuations and minimum funding requirements over that period.

When interest rate stabilization was first adopted by Congress (as part of another highway bill, the 2012 Moving Ahead for Progress in the 21st Century Act (MAP-21)), many argued that interest rates were unusually low, as a result of (among other things) Fed monetary policy, and that interest rate “stabilization” would, in effect, tide DB sponsors over this period of outlier-low interest rates.

Whatever I thought at the time, thinking about these issues over the last seven years I’ve concluded that none of that is true. Low rates are here-to-stay for the foreseeable future, largely because of demographics.

But, my support for HATFA, and its further extension, has, if anything, grown stronger. Because it works, much better than the funding regime originally propounded under the 2006 Pension Protection Act (PPA).

Here’s why.

Why PPA minimum funding requirements failed

Perhaps the most important provision of ERISA, when it was originally adopted in 1974, was Title IV – ERISA’s Plan Termination Insurance system. Over time, some policymakers became concerned, however, that this system might become insolvent without stronger funding incentives.

As many policymakers recognized at the time, there were two ways of solving this problem. The one they chose was, in the PPA, to impose a solvency regime—a complicated and rigid set of minimum funding requirements—on the private defined benefit (DB) plan system.

The problems this solution created were made vivid—and to some extent intolerable—by the global financial crisis that hit just as PPA’s new funding regime took effect in 2008.

It turned out that—in the view of a pretty broad consensus—the cash demands that the new system put on DB plan sponsors were not good for a now-struggling economy.

It also forced plans into a design straitjacket, where if, purely because of an interest rate driven drop in funded status, plan funding fell below 80%–design changes, like a lump-sum window, were prohibited.

And (a correlated problem), in time of severe economic stress, with unemployment at nearly 10% in 2010, it was also really bad for Congressional budget math. All the additional required contributions were going to reduce the taxes DB sponsors paid.

The (better) alternative solution to the PBGC/minimum funding policy challenge

And so Congress turned to what had always been the available alternative. Instead of imposing a strict funding regime on plans that—in many cases presented no risk to the Pension Benefit Guaranty Corporation (PBGC) insurance system—it simply increased the cost of insuring unfunded benefits, by increasing the PBGC variable-rate premium from 0.9% of unfunded vested benefits (UVBs) in 2008 to 4.5% in 2020.

This approach allowed sponsors to make their own decisions about the trade-offs between funding or using available cash for more pressing purposes—an option that was unavailable under the original PPA mandatory funding regime—while (I would argue) doing a better job of maintaining the soundness of the PBGC single-employer insurance system.

Here’s proof

The proof is in the actual experience. Here is a table showing PBGC’s single employer program surplus (deficit) from 2008, when PPA’s mandatory funding rules were effective, through 2019.

Table: PBGC’s Single Employer System Deficit

Variable-Rate Premium ($ in billions)

 Deficit

VRP (as a % of UVBs)

2008

 $ (10.68)

0.9%

2009

 $ (21.08)

0.9%

2010

 $ (21.59)

0.9%  

2011

 $ (23.27)

0.9%  

2012

 $ (29.10)

0.9%  

2013

 $ (27.40)

0.9%

2014

 $ (19.30)

1.4%

2015

 $ (24.10)

2.4%

2016

 $ (20.60)

3.0%

2017

 $ (10.90)

3.4%

2018

 $ 2.48

3.8%

2019

 $ 8.78

4.3%

Variable-rate premiums (VRPs) go up, the PBGC single-employer system deficit goes down and, in the last two years and for the foreseeable future, is in surplus.

Extend HATFA now

In the current situation—with the dramatic decline in interest rates in 2019 making it likely that in 2020 and after U.S. DB plan sponsors are going to face increasing and unnecessary cash stress because the return of PPA’s funding straitjacket—the first thing that is needed is an extension of HATFA relief, indeed, if possible, an expansion of that relief.

Improvements needed

None of that is to say that the current system is perfect. There is widespread concern that high (and increasing) variable-rate and per capita premiums—the latter going from $33 in 2008 to $83 in 2020—are driving well-funded plans out of the system, both through risk transfer and lump sum de-risking transactions and through plan terminations.

I offer the following reforms as a place to start:

Reduce the PBGC per capita premium by half, say to $40. These (the plans for whom the per capita premium is an issue) are the plans we want to keep in the system.

Replace the VRP cap, which in effect encourages plans with high per capita liability to reduce PBGC headcount, with a special extended funding schedule, and with premium relief, for plans with large legacy liabilities.

Stop the “indexing” of the VRP—there never has been any rationale for this provision—its advocates don’t seem to understand how percentages work.

Substantially reduce the VRP rate. At current levels, and even in a context of dramatically declining interest rates and ballooning valuations, it is producing a significant surplus. That is a bad thing—money is being sucked out of the economy to pad PBGC’s books. How about starting with 3% of UVBs? Based on prior experience (see the table above), at that rate VRPs would continue to improve PGBC’s financial position.

Michael Barry is president of O3 Plan Advisory Services LLC. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly http://moneyvstime.com/  about retirement plan and policy issues.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.

Institutional Investors Feel Braced for Whatever the Market Throws Them

They favor active management, most have turned to private markets, and nearly half are using scenario analysis to prepare portfolios for political risk.

In the year ahead, institutional investors surveyed by Natixis Investment Managers rank volatility as their top portfolio risk (53%), with 77% saying they expect greater volatility specifically in the stock market and 67% expecting greater volatility in the bond market.

Almost half (48%) believe that equities are due for a correction in 2020. With the U.S. in the midst of its single longest economic expansion on record, and other markets continuing to shine, still institutions have some concerns that prices are inflated and stocks are overvalued.

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Yet institutional investors aren’t making big changes to their portfolios, and instead, are waiting out the current cycle until they’re comfortable enough with market conditions to make any portfolio moves. “Institutional investors have been steadily fortifying their portfolios in anticipation of inevitable changes in the market cycle that could make 2020 a bumpy ride for unprepared investors,” says David Giunta, CEO for the U.S. at Natixis Investment Managers. “Despite a substantial amount of uncertainty next year, institutional investors remain focused on their long-term objectives and continue to see actively managed, diversified portfolios as a prudent path to outperformance.”

Institutional investors show a belief that active management will guide them through more volatile markets. Nearly three-quarters (74%) say the market environment in 2020 is likely to be favorable for active portfolio management. They continue to increase their allocations to active strategies while their use of passive strategies continues to decline. Current allocations are split 71% active and 29% passive, up from 64% allocated to active management and 36% to passive when surveyed in 2015.

Institutional investors’ projected allocations heading into 2020 remain relatively unchanged. Natixis found most have turned to the private markets, primarily for diversification (62%) and more attractive returns (61%) than they expect from traditional stocks and bonds. Most institutions now use private equity (79%) and private debt strategies (77%), and two-thirds (68%) see private assets playing a more prominent role in their long-term portfolio strategy, despite associated liquidity risks. Seven in ten (71%) institutional investors feel the return potential of private assets is worth the liquidity tradeoff.

Next year, 37% of institutional investors plan to increase their allocations to private debt as well as private equity (28%), real estate (29%) and infrastructure (32%). However, 86% of institutional investors are concerned about too much money chasing too few deals in the year ahead, and three-fourths wonder if public markets are now overvalued.

Preparing for the presidential election

In 2020, institutional investors will be watching the U.S. presidential election carefully. Overall, 64% project that the election cycle will result in market volatility. More immediately, 54% believe impeachment proceedings will have a destabilizing effect on the markets.

In terms of who wins, institutions are split on the performance outcome. Just over half (52%) think the market will respond favorably to a new president, while 54% see an unfavorable reaction should the Democrats win both houses of Congress. Elections may present some short-term performance concerns, but policy may have a longer-lasting impact, as 73% believe trade disputes will have a negative impact on performance.

Either way, institutions are deploying three key strategies to prepare portfolios for political risk. Most frequently they are looking to scenario analysis (48%) and establishing capital buffers and reserves (47%) to manage the risks. Nearly one-third simply say they will need to be nimble and agile in their approach in 2020.

Natixis surveyed 500 institutional investors that collectively manage more than $15 trillion in assets for pensions, insurers, sovereign wealth funds, foundations and endowments around the world.

The full survey report is available for download at https://im.natixis.com/us/research/institutional-investor-survey-2020-outlook.

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