Administration July 16, 2020

Forty Percent of DB Plans Could Adopt Strategies to Lower PBGC Premiums

Strategies regarding timing and recording of pension contributions translate to millions of dollars in lower PBGC premiums, according to a report from October Three.

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For thousands of defined benefit (DB) plan sponsors, sound pension management has become, in large part, management of Pension Benefit Guaranty Corporation (PBGC) premiums, October Three notes in its fourth annual PBGC Premium Burden report.

PBGC premiums for single-employer plans are calculated as the sum of a flat-rate premium ($83 per participant in 2020) plus a variable-rate premium (4.5% of unfunded PBGC liability in 2020, with a cap of $561 per participant). The flat-rate premium (FRP) more than doubled between 2010 and 2019 (from $35 to $80 per participant), and the median plan saw its FRP double as well (from $43,000 in 2010 to $86,000 in 2019).

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For the variable rate premium (VRP), while there was a decrease in 2017 and 2018, premiums bounced back in 2019 due to poor 2018 asset performance. Other variables, such as employer contributions, benefit accruals and capital market fluctuations, also affect the VRP. Since 2010, the VRP rate has increased almost five-fold (from 0.9% in 2010 to 4.3% in 2019), while the median VRP paid has increased by more than seven times (from $22,000 to $167,000).

October Three notes that good asset performance in 2019 is expected to help offset 2020 premium increases, but it warns that premiums are likely to spike higher in 2021 based on adverse capital markets in the first half of 2020.

The report’s analysis focuses only on the roughly 5,000 plans that cover at least 250 participants.

A minority of plans (more than 30% in 2019) are overfunded and didn’t owe any VRP. At the other extreme, 30% of plans saw premiums limited by the VRP cap in 2019, a percentage that has grown steadily. October Three notes that it is the plans in the middle, about 40% of plans in 2019, for which adopting best practices regarding timing and recording of pension contributions translates to millions of dollars in lower PBGC premiums.

“Minimizing PBGC premiums depends on plans’ maximizing the use of ‘grace period’ contributions—amounts contributed to a plan after the end of the plan year but still attributable to that plan year. This is what we call best practices. Failure to adopt best practices around quarterly contribution requirements and applying funding balance has caused plan sponsors to pay higher PBGC premiums than necessary due to not maximizing and getting full credit for grace period contributions,” the report explains. “In many cases, all or part of contributions made to satisfy quarterly contribution requirements could have been characterized as grace period contributions but weren’t. So, plans often report lower asset values than they could have and, as a result, pay higher premiums than they need to.”

October Three notes that, sometimes, this strategy for minimizing PBGC premiums can’t be done. Plans that are less than 80% funded must make cash contributions to satisfy funding requirements, and other plans that don’t satisfy prior year requirements until the funding deadline can’t record grace period contributions optimally.

Another best practice the firm recommends involves modest acceleration of pension contributions. For a calendar year plan that was at least 80% funded in the prior year, it recommends:

  • Accelerating quarterly contributions due on October 15 to September 15 and recording those contributions for the prior year;
  • Accelerating residual minimum required contributions due on September 15 to April 15, which allows plans to record April 15 and July 15 contributions for the prior year;
  • Accelerating quarterly contributions due on January 15 to September 15 and recording those contributions for the prior year; and
  • Accelerating voluntary year-end contributions to September 15 and recording those contributions for the prior year.

“The accelerations above are modest—from as little as one month to five months at the most. And, other than voluntary year-end contributions, these contribution amounts are usually known months in advance,” the report says. “But the payoff to plan sponsors could be huge. Our analysis indicates that failure to adopt these best practices has caused plan sponsors to pay $1.2 billion more in premiums between 2011 and 2018 than they needed to.”

The election of the rate used to measure unfunded vested benefits (UVBs) may have a material effect on how much PBGC variable-rate premiums a DB plan sponsor must pay. October Three explains that the “standard” liability measurement for calculating PBGC premiums is based on the most recent monthly spot rates (December 2019 rates for 2020 premiums for calendar year plans), but PBGC allows an “alternative” liability measure based on 24-month average interest rates (with a 0- to 4-month lookback, depending on the plan’s minimum funding election). Plans may move from one method to the other but are “locked in” for five years after each move, so some plans may not have a chance to change their election for 2020.

According to October Three’s data, at least 120 plans with at least 250 participants changed to the standard method in 2019, reducing their premiums by an estimated $130 million compared with the alternative method. However, interest rates fell dramatically during 2019, so that for 2020, the PBGC alternative method produces a much lower liability than the standard method. Barring unusual situations—for example, plan merger or termination, 2020 contribution to fully fund plan, significant headcount reductions triggering the VRP cap—many DB plan sponsors that elected the standard method for 2019 will see 2020 premium increases more than offset the 2019 savings.

“Given that the 2019 election was not due until October 15 and interest rates had already fallen by then, this unfortunate election could have been avoided by looking just one year ahead. Making matters worse, rates have continued to fall during 2020, so the standard method will likely produce a higher PBGC premium for 2021 as well,” the report states.

October Three recommends that plans that are free to elect the alternative method for 2020 should do so. However, it advises revisiting the interest rate environment in early October before making a final election.

Investing July 16, 2020

Some Say Coronavirus Will Cement New Normal for Rates

The world has indeed embraced a new normal—but not one necessarily tied to interest rates.

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Back in mid-2019, PLANSPONSOR published an article titled “Explaining the New Normal for Interest Rates.”

In that story, Bob Browne, chief investment officer (CIO) at Northern Trust, summarized the “new normal” argument as follows: “I continue to be surprised by my fellow asset management professionals who think that the long-term norm for the 10-year U.S. Treasury should, by historical standards, be closer to 4% or even 4.5%. This is just too high when you consider, among other facts, that there is $15 trillion invested the bond markets globally right now that is carrying a negative interest rate.”

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Browne and others explained this as one of the lingering legacies of the Great Recession. On the day the article was published, the Swiss 10-year was trading at negative 90 basis points (bps), the German 10-year was trading at negative 56 basis points and the Japanese 10-year was at minus 20 basis points. So even if the global economy had enjoyed a record-long bull run during the 2010 to 2019 decade, why would a U.S. 10-year government bond trading at close to 1.5% or 1.75% seem low? That rate was in fact unusually high in the global context.

Fast forward to mid-2020 and the world has indeed embraced a new normal—but not one necessarily tied to interest rates. Investors and economies are grappling with the coronavirus pandemic, which has upended fundamental aspects of peoples’ lives all around the world. As the pandemic unfolded, concerns about vast and long-lasting economic damage sent the equity markets tumbling in March, though they rebounded significantly in April and May. Today, the equity market volatility continues unabated, with daily swings in excess of 1% or 2% being quite common.

But what about bond yields and the fixed-income side of the portfolio? For starters, negative rates persist across well-established economies in Europe, and yields here in the U.S. are only marginally higher, given the massive demand for “safe assets.” The U.S. 10-year bond interest rate, as of midday on July 16, is a mere 0.613%.

“While there is a lot that is unclear about the future of the global economy and the markets, it is abundantly clear that interest rates are going to stay very low for quite a long time,” warns Brett Wander, chief investment officer for fixed income at Charles Schwab Investment Management. “The U.S. Federal Reserve has emphasized it is planning to not raise rates for at least a number of years—not just a few months as they would normally signal. Crucially, this sentiment has already been priced into the marketplace, and, in fact, there is no consensus that rates will rise any time before, say, 2022. We are in a very new world for interest rates—we already were before the virus struck.”

Wander says asset managers are having to confront and rethink the classic idea that, when yields fall so low, investors should simply forego investing in bonds.

“Money managers may have agreed with that sentiment previously, but in the new normal, that’s just not true anymore,” Wander says. “What is required is that we continue to contemplate and evolve the role of fixed income in the holistic portfolio, starting from the point of accepting that rates can stay lower for longer than people previously thought possible.”

Wander says the purpose of fixed income in this environment will be to deliver stability and a ballast to the portfolio. Given that rates are not going to rebound, it is just not rational to expect government bonds to be a major producer of returns over time.

“Rather than accepting this, there is a tendency among many investors to put too much of an emphasis on yield, perhaps because they remember previous periods when fixed income delivered handsomely and even on par with equities in some markets,” he explains. “This causes them to ‘reach for yield,’ meaning that they accept bonds with lower and lower credit ratings as a means to increase the projected return. In my view, this is one of the biggest mistakes investors can make right now.”

Wander says investors taking this track of reaching for yield tend to both overestimate their excess potential return while underestimating the additional uncompensated risk they are adding to their portfolio as a whole.

“Nobody is really happy about it, but we have to accept the new normal and shy away from simply piling on risk in what is meant to be the stabilizing part of the portfolio,” Wander says.

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