Investing January 13, 2023

Corporate Pension Funding Marginally Retreated From Levels To End 2022

December equity performance reduced pension funding levels from highs earlier in the year.

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MetLife Investment Management, the institutional asset management business of MetLife Inc., estimated that, as of November 7, 2022, the average U.S. corporate pension funded status stood at 106.3%, the highest level in the past 10 years. By the end of 2022’s third quarter, the average funding status was 104.7%, still 4 percentage points above the end of the Q2.

“The increase in interest rates seen in 2022 has improved pension funded status and provided attractive yields for sponsors wanting to de-risk by increasing their allocation to fixed income,” wrote Stephen Mullin, head of high-grade strategies for MetLife, at the time.

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Since then, however, funded status has dropped.

LGIM America’s Pension Solutions Monitor, which estimates the health of a typical U.S. corporate defined benefit pension plan, estimated that pension funding ratios decreased through December 2022, with the average funding ratio dropping to 98.3% by the end of the year, down from 100.2% at the end of November 2022.

Global equities and the S&P 500 dropped 3.9% and 5.8%, respectively, in December, notable examples of the the prevailing outcome during the month. Equity losses outpaced miniscule increases in discount rates, estimated by LGIM America at roughly 11 basis points over the month, with the Treasury component increasing 15 bps and the credit component tightening 4 bps. Pension funds within a traditional “60/40” asset allocation decreased 2.5%, while liabilities decreased by 0.6%, resulting in a 1.9-percentage-point decrease in funding ratios by December month-end, according to LGIM America.

The year-end results of the Milliman 100 Pension Funding Index , which analyzes the 100 largest U.S. corporate pension plans, showed that corporate pension funding improved by $172 billion in 2022, while plans’ funding ratio closed the year at 110% funded, down in Q4 of 2022 but up from 97.9% at the end of 2021.

Rising discount rates throughout 2022 drove this result, as the PFI discount rate soared 242 bps over the course of year, reaching 5.22% on December 31, the highest year-end rate in more than a decade.

According to Insight Investment, the aggregate funding status of corporate defined benefit plans declined by 2.3 percentage points to 101.8% from 104.1% during December. Assets decreased by 2.9%, and liabilities decreased by 0.8%. The average discount rate rose by 6 bps to 5.11% in December from 5.05% in November.

According to Agilis, in its pension briefing on funding status, pension funding improved significantly on an economic basis for many plan sponsors during the year, despite the S&P 500 posting its worst year since 2008. “The substantial rise in discount rates and the corresponding lower pension liabilities left many plan sponsors in substantially better shape at the end of 2022 compared to the beginning of the year,” Agilis managing director Michael Clark wrote. “That said, there is a lot to be cautious about heading into 2023. Fears of recession are still causing markets to be volatile, and while funded status improvements as a result of higher discount rates has been welcomed news, if rates go back down, plan sponsors could find themselves in a far worse position if markets don’t correspondingly rebound.”

According to October Three’s December monthly pension update, pension finances held up well, buoyed by the largest increase in interest rate seen since at least 1980, in the face of the fourth-worst year for equities since 1950.

Stocks fell broadly in the month of December, capping the worst year for the stock market since 2008 with a losing month. A diversified stock portfolio lost 5% last month and 20% overall during 2022. Bonds lost almost 1% during December and 15%-25% for the year, the worst performance in more than 40 years. Long duration and corporate bonds performed worst, as interest rates edged higher in December, ending a historic year which saw rates increase from below 3% at the end of 2021, to 5% or more at the end of 2022.

October Three’s data showed that the traditional 60/40 portfolio lost more than 3% during December and more than 18% for the year, while the conservative 20/80 portfolio lost more than 1% last month, also ending the year down more than 18%.

“2022 was the year of the great shrinking pension balance sheet, with many plans seeing both assets and liabilities contract around 20%,”  wrote Brian Donohue and John Lowell for October Three December pension finance update, leaving the typical plan better funded than at the end of the previous year. However, experiences will vary among individual pension funds based on their asset allocations, stock selection, bond credit quality and duration, and liability profile.

According to Wilshire Associates research, the aggregate funded ratio for U.S. corporate pension plans decreased by 0.7% month-over-month in December to end the month at 98.6%, lower than the 99.3% recorded at the end of November.

The monthly change in funded ratio resulted from a 2.6% decrease in asset values, partially offset by a 1.9% decrease in liability values. The aggregate funded ratio is estimated to have increased by 3.2% and 2.4% during Q4 and over the calendar year 2022, respectively.

According to analysis by WTW, the funding status of the nation’s largest corporate defined benefit pension plans ended 2022 at roughly the same level as it began the year, as weak investment returns offset lower pension liabilities created by higher interest rates.

Examining pension plan data for 356 of the Fortune 1000 companies that sponsor U.S. defined benefit pension plans, WTW estimates that the aggregate pension funded status is 95%. Furthermore, pension obligations declined 26% from $1.73 trillion at the end of 2021 to an estimated $1.28 trillion at the end of 2022, with the funding deficit projected to be only $62 billion at the end of 2022, down from $80 billion at the end of 2021.

WTW reports that pension plan assets declined 26% in 2022, finishing the year at $1.22 trillion, partially accelerated by another record year in pension risk transfers and cash contributions that were lower than in typical years.

Overall investment returns are estimated to have averaged a 19% decline in 2022, although returns varied significantly by asset class. Domestic large capitalization equities, as well as domestic small/mid-capitalization equities, both fell by 18%. Aggregate bonds recognized losses of 13%, while long duration corporate and long government bonds, typically used in liability-driven investing strategies, realized losses of 25% and 29%, respectively.

“We believe plan sponsors should stay vigilant in 2023 as volatility and downside risk remain,” wrote Joanie Roberts, senior director of retirement at WTW. “The decline in asset values during 2022 may have increased the risk of future pension contributions for many plan sponsors. With some economists forecasting a potential recession in 2023, sponsors will want to revisit how their strategy for managing pension risk needs to evolve.”

Compliance January 13, 2023

Ibuprofen Stock Surges as Plan Sponsors Read New DB Plan Rules in SECURE

SECURE 2.0 makes several regulatory and disclosure changes for DB plans.

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Although the SECURE 2.0 of 2022 primarily focused on defined contribution plans, it also contains reforms to defined benefit plans.

Section 342

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Section 342 of SECURE 2.0, which John Lowell, a partner in October Three, an actuarial consulting firm, describes as the biggest change to DB plans found in the legislation, changes disclosure rules for DB plans that offer lump sum payments.

DB plans often offer participants an opportunity to receive a lump sum instead of an annuity, which sponsors sometimes encourage, since when they remove the participant from the plan, they pay less insurance to the Pension Benefit Guaranty Corporation.

Lowell explains that Congress was concerned that many participants were making bad financial choices related to these lump sums, so they required new disclosures for DB plans that offer them.

Former PBGC Director Joshua Gotbaum, now a guest scholar at Brookings, was more critical: “For years, the federal government has allowed businesses to get out of their pension obligations by offering cash settlements to their employees, frequently in amounts that are much less than insurance companies would charge to assume those obligations.  Most people took the check, which was often for tens of thousands of dollars, without knowing that their pension rights were worth far more, and the government didn’t require that they be told.  Now, finally, Congress is acting to help those who still have their pensions.”

The new rules under Section 342 require the plan to communicate the following to participants at least 90 days before the lump sum becomes available: the value of the lump sum relative to annuities available under the plan; the interest rate and mortality figures used to calculate the lump sum; that buying their own annuity with the lump sum could be more expensive than taking an annuity under the plan; and the tax rules involved in taking a lump sum.

The plan must also inform the Department of Labor of the following: the timing of the lump sum window at least 30 days before it opens; how many participants are eligible for lump sum payments; how the lump sum is calculated; and sample copies of related notices given to participants.

These DB plan sponsors must also provide contact information and a point of contact for participants to call about these disclosures, and Lowell remarks, “I pity that poor person.”

The DOL has one year after the enactment of SECURE 2.0 to issue regulations implementing Section 342, which include issuing a model disclosure form, according to Gotbaum.

Many plan participants have already taken lump sums without knowing it may not have been in their best interest. Gotbaum says, “After more than a million horses have left the barn, the federal government says you should put up a sign saying that, ‘By the way horses, you have other options,’ i.e. you’re being screwed.”

Mortality Improvements

Section 335 says mortality improvements from one year to the next cannot be more than 0.78%. This, according to Lowell, “will reduce actuarial liability in pension plans.”

Bruce Cadenhead, partner and global chief actuary in wealth at Mercer, provides an example of what this would mean in practice. Say, hypothetically, that 1% of 65-year-olds die every year. When projecting future mortality of 65-year-olds, you could not reduce that percentage by more than 0.78%, meaning 1% could not be reduced below 0.9922%, even if the best available data suggests the rate would be lower.

Cadenhead says this provision is flawed, because 0.78% is an average of mortality improvement across age groups. At younger ages especially, mortality rates have been declining faster than 0.78%, which reduces the accuracy of mortality tables and also reduces the age-by-age flexibility actuaries have.

According to Cadenhead, this provision raises a small amount of revenue in budget scoring, because it artificially slows the rate of life longevity growth, which causes pension liabilities to decrease which causes participant contributions to decrease and, finally, related federal income tax deductions to decrease.

This provision was made in reaction to mortality tables made in recent years that proved to be too optimistic (from the point of view of participants) and which increased pension liabilities, according to Cadenhead. The Society of Actuaries corrected the issue on their own, so this is a “highly technical correction for a problem which no longer exists.”

PBGC insurance rates

SECURE 2.0 will cap the variable-rate PBGC insurance premium at 5.2% of unfunded liabilities and un-link it from inflation going forward.

For more on PBGC insurance rate changes, see our issue-specific coverage here.

Cash balance plans

For the purposes of passing IRS backloading tests for cash balance plans, sponsors can assume a reasonable rate not to exceed 6% in determining interest credits. A higher interest rate can reduce the impact of backloading pay credits to older employees, since that interest will compound more for younger employees receiving lower pay credits.

For more on changes to cash balance plans, see our issue-specific coverage here.

Smaller Changes

Section 321 requires the DOL to re-evaluate interpretative bulletin 95-1, which requires DB plans that purchase annuities on behalf of participants to choose the safest possible annuity provider. This section orders them to review it, but it does not require them to change it. Lowell says that 95-1 is “vague,” and he suspects this section is intended to push the DOL toward being more specific.

Section 324 requires the Treasury Department to simplify pension-to-IRA rollovers by providing sample forms for both the incoming and outgoing retirement plan or IRA and regulatory guidance.  Lowell says this “feels very small but will affect everyone a little bit.”

SECURE 2.0 also makes clear that all qualified plans can make distributions without an early-withdrawal penalty if the participant has a terminal illness. This applies mostly to DC plans, but also to DB plans that offer a lump sum since it could no longer penalize early distribution for the terminally ill.

Section 327 changes the required minimum distribution rules (which were also changed by the new law) to permit a surviving spouse to elect to be treated as an employee for the purposes of applying the RMD. This will allow more financial flexibility, especially for those who are considerably younger than their deceased spouse, according to Lowell.

Although it mostly applies to DC plans, SECURE 2.0 also increases the required minimum distribution age for pension funds to 73 for 2023 and 75 in 2033. Since many DB plans require participants to take benefits before age 73 or 75, few will be affected, according to Cadenhead.

According to Cadenhead, DB plans that have surplus assets are allowed to make transfers to provide retiree medical benefits, known as 420 transfers. The statutory authority for these transfers has always had an expiration date, and SECURE extends that date to 2032.

From the point of view of a defined benefit plan sponsor, Lowell says SECURE 2.0 “created additional complexity more than it did anything else.”

 

 

 

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