July 2021 DB Plan Funded Status Shows Vulnerability to Interest Rate Risk

As discount rates used to measure pension liabilities fell, many plans’ funded status slipped, although the degree of loss depended on a plan’s liability profile and investment mix.

According to River and Mercantile’s “US pension briefing – July 2021,” discount rates used to measure liabilities for corporate defined benefit (DB) plans fell nearly 0.15% during July, translating to liability increases of approximately 2% for a typical plan.

Market performance was generally positive for July, with both U.S. fixed income and equities up 1% to 3% for the month. With returns offsetting the effects of increased liabilities, most pension plans’ funded status should have seen little movement over the past month. River and Mercantile notes that whether that movement is positive or negative will depend on a plan’s specific liability profile and mix of investments.

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

Northern Trust Asset Management (NTAM) found that the average funded ratios of DB plans for S&P 500 companies were largely flat in July, moving from 93.4% to 93.3%. It found that higher liabilities due to lower discount rates offset positive equity returns. According to NTAM, global equity market returns were up approximately 0.7% during the month. The average discount rate decreased from 2.49% to 2.38% during the month, leading to higher liabilities.

Aon also found that S&P 500 aggregate pension funded status remained flat during the month of July, pegging it at 92.4%. According to its Pension Risk Tracker, asset returns were positive throughout July, ending the month with a 1.3% return. The month-end 10-year Treasury rate decreased 21 basis points (bps) relative to the June month-end rate, and credit spreads widened by 12 bps. This combination resulted in a decrease in the interest rates used to value pension liabilities from 2.61% to 2.52%. Aon notes that the majority of plans in the U.S. are still exposed to interest rate risk.

However, other firms that track DB plan funded status found the movement from the end of June to the end of July was slightly negative. And, as River and Mercantile said, other reports showed the degree of loss differed based on a plan’s specific liability profile and mix of investments.

NEPC notes in its “July 2021 Pension Monitor” that equity performance was largely overshadowed by fixed income, likely leading to greater losses in funded status for total-return plans relative to their liability-driven investing (LDI)-focused peers. Based on NEPC’s hypothetical open and frozen pension plans, the funded status of the total-return (open) plan fell 1.8%, while the LDI-focused (frozen) plan declined 0.1% during the month.

LGIM America estimates that pension funding ratios decreased approximately 0.7% throughout July, primarily due to declining Treasury yields. Its calculations indicate the discount rate’s Treasury component decreased 18 bps while the credit component widened 6 bps, resulting in a net decrease of 12 bps. According to LGIM America’s Pension Solutions Monitor, overall, liabilities for the average plan increased 1.7%, while plan assets with a traditional 60/40 asset allocation rose approximately 0.9%.

Both model plans October Three tracks lost ground last month. Plan A dropped 1% in July but remains up 9% for the year, while the more conservative Plan B lost a fraction of 1% last month and remains up more than 2% through the first seven months of the year. 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.

Insight Investment estimates that DB plan funded status declined by approximately 70 bps, from 93.8% to 93.1%, during July. However, Shivin Kwatra, head of LDI portfolio management at Insight Investment, points out that “funded status continues to be robust in 2021, averaging over 90% for the year.”

During 2021, the aggregate funded ratio for U.S. pension plans in the S&P 500 has increased from 87.9% to 92.4%, according to the Aon Pension Risk Tracker. The funded status deficit decreased by $114 billion, which was driven by liability decreases of $83 billion, combined with asset increases of $31 billion year-to-date.

Aside from continuing to manage interest rate risk, corporate DB plan sponsors have decisions to make regarding the funding of their plans. Brian Donohue, a partner at October Three Consulting in Chicago, notes, “Pension funding relief was signed into law during March. The new law substantially relaxes funding requirements over the next several years, providing welcome breathing room for beleaguered pension sponsors.”

Michael Clark, managing director and consulting actuary with River and Mercantile, says plan sponsors “will want to consider what the ‘right’ contribution to make to their plan is, given that many sponsors will have substantially reduced or even no required contributions at all.” He adds that plan sponsors with calendar year plans that want to reduce their annual Pension Benefit Guaranty Corporation (PBGC) premiums may find value in making a contribution prior to September 15.

ESG Regulation Submitted to OMB by DOL

The title of the regulation also suggests it will address the related but distinct issue of proxy voting advice and shareholder activism among retirement plan fiduciaries.

The U.S Department of Labor (DOL) has submitted a new proposed regulation to the White House’s Office of Management and Budget (OMB), titled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.”

The submission represents a key step forward for the Biden administration’s stated plans of modifying the regulatory framework that controls retirement plan fiduciaries’ actions when considering and using environmental, social and governance (ESG)-themed investments. The title of the regulation also suggests it will address the related but distinct issue of proxy voting advice and shareholder activism among retirement plan fiduciaries.

For more stories like this, sign up for the PLANSPONSOR NEWSDash daily newsletter.

OMB typically reviews proposed regulations within 60 days from the date of their submission or publication of the 30-day Federal Register notice—whichever is later—but, in some circumstances, the process can take longer.

Sources expect the forthcoming regulations to take a substantially different track compared with the work of the Trump administration, which finalized new restrictions on the use of ESG funds and proxy voting advisers by retirement plan fiduciaries late in 2020.

With respect to ESG investments, although the final 2020 rule did not expressly limit the use of ESG funds, given its framing of the “pecuniary” concept, experts argued it would still likely have that effect if or when it was enforced. This is because fiduciaries would seemingly have to comb through an ESG fund’s prospectus and marketing materials for any references to non-pecuniary factors being used in the investment process. Such requirements present potentially significant legal risk to fiduciaries and, therefore, may deter some from considering ESG funds.

Similar concerns have been voiced by stakeholders in the financial services and retirement planning industry with respect to the proxy voting regulation implemented late last year. In basic terms, the final rule confirmed that proxy voting decisions and other exercises of shareholder rights must be made “solely in the interest of providing plan benefits to participants and beneficiaries considering the impact of any costs involved.” As the DOL stated under former President Donald Trump, the proxy voting rule seeks to ensure that plan fiduciaries do not subordinate the interests of participants and beneficiaries in their retirement income or financial benefits under the plan to any non-pecuniary objective or promote non-pecuniary benefits or goals.

When the DOL first issued its final rule on benefit plan proxy voting, some retirement industry stakeholders voiced concern that it risked seriously chilling proxy voting activities and other forms of shareholder engagement executed by investment managers and other parties on behalf of retirement plan investors. Similar fears were raised on the ESG front, leading the Biden administration to adopt a nonenforcement policy as it reviews both regulations.

Given President Joe Biden’s words and actions regarding the importance of fighting climate change and promoting corporate social responsibility, experts say it is almost certain that the current DOL will move to ease those concerns about proxy voting and ESG activities.

That said, some insiders think the Biden administration’s proposal itself may not have to be radically different from the pecuniary-focused framework already in place, in part because the final version of the ESG rule included important changes relative to the proposal. Chief among these changes is the fact that the text of the final rule no longer refers explicitly to “ESG” as an investment theme that deserves additional scrutiny. Rather, as noted, it presents a framework that emphasizes that retirement plan fiduciaries should only use pecuniary factors when assessing investments of any type—which is to say that they should only use factors that have a material, demonstrable impact on performance.

Editor’s note: PLANSPOSOR Magazine is owned by Institutional Shareholder Services (ISS). ISS has engaged in litigation related to the Trump administration’s proxy voting regulations.

«