Corporate DB Plan Funded Status Improves to Pre-Pandemic Levels

Equity allocations gave some plans a boost, and experts anticipate new legislation will offer relief from expected higher contributions.

Corporate defined benefit (DB) plan funded status improved from 86% at the end of January to 88% at the end of February, according to Insight Investment.

“Through February, discount rates have risen approximately 45 bps [basis points], which has caused the liability to drop approximately 5%. Assets have remained level with the losses in fixed income due to rising rates offset by gains in the return-seeking asset portfolio,” says Kevin McLaughlin, Insight’s head of liability risk management.

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According to River and Mercantile’s “US Pension Briefing – February 2021,” overall, most pension plans should see their funded status improve for the month, particularly those with higher equity allocations. Pension discount rates continued increasing in February and are up almost 0.5% so far this year, which means lower liabilities for pension plan sponsors. Equity market returns were positive across the board, riding on good COVID-19-related news.

“Pension plan funded status continues to improve in 2021 with rates and equities moving in the right directions for plan sponsors. In addition, the Emergency Pension Plan Relief Act of 2021 [EPPRA] continues to be included in the larger stimulus bill that is making its way through Congress,” says Michael Clark, managing director and consulting actuary with River and Mercantile. “If passed, it will provide many plan sponsors substantial flexibility in deciding how much to contribute to their pension plans in the near future. With pressure taken off cash requirements, it’s likely that we’ll see an increase in allocation to equities to help close any funding gaps for some plan sponsors.”

The average funded ratio of corporate DB plans in the S&P 500 improved in February from 87.9% to 91.3%, according to Northern Trust Asset Management (NTAM). Positive returns in equities along with the increase in discount rates led to the higher funded ratio. Global equity market returns were up approximately 2.3% during the month. Average discount rates increased from 2.32% to 2.61% during the month, leading to lower liabilities.

“Strong equity markets combined with this increase in discount rates have taken average funded ratios to above pre-pandemic levels,” notes Jessica Hart, head of the OCIO [outsourced chief investment officer] retirement practice at NTAM.

Ned McGuire, managing director at Wilshire, also points out that, “February’s liability value decrease was the largest since March 2020 when the markets first reacted to the COVID-19 pandemic.”

Wilshire’s estimate of funded status for S&P 500 companies shows the aggregate funded ratio increased by an estimated 3 percentage points month-over-month in February to end the month at 90.8%. The monthly change in funding resulted from a 4.4 percentage point decrease in liability values partially offset by a 1.1 percentage point decrease in asset values. The aggregate funded ratio is estimated to have increased by 4.0 and 9.2 percentage points year-to-date and over the trailing 12 months, respectively.

According to the Aon Pension Risk Tracker, the aggregate funded ratio for DB plans in the S&P 500 has increased from 91.5% to 95.1%, the highest on record since Aon began tracking the funded ratio for the S&P 500 in 2011. The funded status deficit decreased by $91 billion, which was driven by liability decreases of $138 billion, partially offset by asset decreases of $47 billion year-to-date.

October Three also says pension finance enjoyed its best month in more than three years in February. Both model plans it tracks gained ground last month: Plan A gained 5% and is now up more than 7% for the year, while the more conservative Plan B added 1% and is now up more than 1% through the first two months of 2021. Plan A is a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, while Plan B is a largely retired plan (duration 9 at 5.5%) with a 20/80 allocation and a greater emphasis on corporate and long-duration bonds.

NEPC’s February 2021 Pension Monitor says that, driven by an increase in Treasury rates and strong equity returns, the funded status of typical corporate pension plans improved in February. It says total-return plans outpaced liability-driven investing (LDI)-focused plans that hedge more interest-rate risk, as losses from fixed-income assets eroded gains from equities. While credit spreads remained mostly flat for the month, the Treasury curve increased and steepened, reducing plan liabilities. Based on NEPC’s hypothetical open- and frozen-pension plans, the funded status of the total-return plan rose 5.2%, while the LDI-focused plan increased 1.9%.

Legal & General Investment Management (LGIM) America estimates that pension funding ratios increased approximately 3.5% throughout February, with the impact primarily due to strong equity performance and higher liability discount rates, according to its Pension Solutions’ Monitor. Its calculations indicate the discount rate’s Treasury component increased 38 bps while the credit component tightened 8 bps, resulting in a net increase of 30 bps. Overall, liabilities for the average plan decreased 3.2%, while plan assets with a traditional 60/40 asset allocation rose approximately 0.8%.

Several firms noted that President Joe Biden’s $1.9 trillion stimulus package would extend DB plan funding relief, saving plans from increases in required contributions. Brian Donohue, a partner at October Three Consulting, says, “This legislation will be crucial to pension decisionmaking in the months ahead.”

Retirement Income: Key Considerations

Peg Knox, with the Defined Contribution Institutional Investment Association (DCIIA), says DC plans need to evolve to prepare participants to convert their assets into retirement income.

Having evolved meaningfully over the past 40 years, today’s defined contribution (DC) plans now enable participants to accumulate and invest retirement assets even more easily than in the past. DC plans also most often allow participants to retain assets in-plan throughout retirement. Yet research indicates that most of them are ill-prepared to convert their assets into retirement income.

The conclusion for DC plan sponsors seeking to assist these participants is clear: The next step is to evolve plan design and investments by adding a benefit distribution focus to offerings and communications and/or by adding services to better address the needs of those near or in retirement. Plan participants have also identified this as an area of need.

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In a presentation at the Defined Contribution Institutional Investment Association (DCIIA)’s November Academic Forum, Michael Finke of The American College of Financial Services shared research showing that in response to the question, “Once you retire, which of the following is the most important attribute of a retirement savings plan?” participants selected as their top choice, “Helps me understand how much I can safely spend in retirement.”

The lifetime (or retirement) income topic is not new—DCIIA has white papers on the topic dating back to 2015, as does this comprehensive article from the American Academy of Actuaries. However, the topic is gaining urgency given demographic trends such as:

  • An increasing number of retiring Baby Boomers;
  • A growing population of Americans aged 65 and older who are also living longer;
  • An escalating reliance on DC plan assets versus defined benefit (DB) plan income; and
  • Workers age 50 and older delaying retirement due to concerns about post-retirement finances.

Public policy developments are also helping spur retirement income discussions, namely the Setting Every Community Up for Retirement Enhancement (SECURE) Act. It addressed lifetime income disclosures, and, in September, the U.S. Department of Labor (DOL) published an interim final rule that will require 401(k) plan sponsors to annually disclose to plan participants estimates of how much income their account balance would produce if used to purchase an annuity. The SECURE Act also provided a safe harbor for selecting an in-plan annuity provider, helping to mitigate previous plan sponsor concerns that limited their ability to consider implementing an annuity component in their plans.

Plan sponsor motivations for considering retirement income solutions may include:

  • Workforce management: If employees aren’t retiring on time, there is an increased benefits cost and it may prevent younger employees from advancing in their careers within the company. Productivity can be impacted when employees are worried about their finances.
  • Recruiting and retention: Offering retirement income solutions as part of a plan’s total offerings may help organizations attract top talent and reward long-term employees.

Employee motivations might include:

  • Seeking help to address overall concerns about low retirement savings levels and/or how to plan for retirement;
  • Longing for a sense of “security” that’s missing in their DC plan combined with an awareness of the feeling of security among those with DB plans; and
  • Looking for a clear path that will facilitate how to turn retirement savings into a viable income stream; assessing options on their own can be expensive and confusing.

In addition, both plan sponsors and employees have been and will continue to be impacted by COVID-19, whether through layoffs/job loss, health issues and concerns about health care costs, or other fallout from the ongoing pandemic.

Retirement Income Solutions

Retirement income solutions cover a wide spectrum of insurance and investment products and advice solutions that can address different participant needs, whether they are in the savings or spending phase. (In previous columns, we’ve touched on annuities and the retirement tier as important aspects of the plan sponsor conversation on retirement income.) The solutions are intended to help participants while maintaining the benefit of institutional oversight and pricing.

Plan sponsors may adopt plan design that allows for flexible distributions/systematic withdrawal programs, provide income tools and calculators (e.g., Social Security optimizer, financial planning and budgeting, health care planning and budgeting, etc.) or engage rollover or distribution consulting services to provide institutional or retail options for participants who are transitioning into retirement or otherwise separating from service. Participants should receive targeted and personalized communications about related educational content and resources.

Specific offerings are typically categorized as either “in-plan” or “out-of-plan” solutions:

In-plan solutions are generally characterized by the fact that assets remain in the plan, either as investment assets or, if a guaranteed product, as a group annuity contract held by the plan. Retirement income is paid from plan assets to retirees, and the underlying assets are included as a part of the plan’s assets for the purpose of government reporting.

Out-of-plan solutions are generally characterized by the transfer of participant assets from the plan directly to a selected financial institution or institutions, typically an insurance company, mutual fund company or broker firm, that generates guaranteed or non-guaranteed income for the retiree from the amounts transferred. The plan sponsor may be involved in identifying these institutions, communicating them to plan participants and facilitating the transfer of assets out of the plan upon retirement. Once assets have been transferred, the plan has no ongoing involvement with the retiree with respect to the transferred assets and the transferred assets aren’t included in the plan’s ongoing government reporting. This is not to be confused with a garden-variety individual retirement account (IRA) rollover, where the plan transfers assets to a financial institution identified by the retiree, as such transactions have not been analyzed or facilitated by the plan sponsors.

Retirement income adequacy should be one of the primary goals for DC plans today, given that participants increasingly rely on their accumulated DC assets to provide them with an income stream in retirement. Plan sponsors’ decisions about their plans’ distribution policies can play a critical role in their participants’ retirement outcomes.

 

Peg Knox is the chief operating officer (COO) of the Defined Contribution Institutional Investment Association (DCIIA) and is a former plan sponsor. Additional resources on this topic are available in DCIIA’s Resource Library.

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 (ISS) or its affiliates.

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