Lower Interest Rates Foil Market Rally Impact on DB Plan Funded Status

The average funded ratio of S&P 500 corporate defined benefit (DB) plans declined in July from 80.0% to 79.1%, according to estimates by Northern Trust Asset Management (NTAM). Positive returns in the equity market were not enough to offset the higher liabilities due to lower discount rates:

NTAM says global equity market returns were up approximately 5.3% during the month. The average discount rate decreased from 2.28% to 1.94% during the month.

Wilshire Associates estimates plans sponsored by S&P 500 companies with a duration in line with the FTSE Pension Liability Index – Short decreased by 1.3 percentage points in July to end the month at 79.9%. The decline resulted from a 5.6% increase in liability values largely offset by a 4.0% increase in asset values. The aggregate funded ratio is estimated to have decreased by 7.2 and 8.9 percentage points year-to-date and over the trailing 12 months, respectively. 

“July’s decrease in funded ratio was driven by the increase in liability values,” says Ned McGuire, managing director and a member of the Investment Management & Research Group at Wilshire Associates. “The increase in liability value was due to an approximate 20 basis point decline in Treasury yields and 15 basis point decline in corporate bond spreads. July marks the first monthly decrease in funded ratio since the market recovery that started in April.”

“Interest rates hit new all-time lows,” says Scott Jarboe, a partner in Mercer’s wealth business. Mercer estimates that the aggregate funding level of DB plans sponsored by S&P 1500 companies decreased by 1% in July to 79%. As of July 31, the estimated aggregate deficit of $557 billion increased by $64 billion as compared to $493 billion measured at the end of June. The S&P 500 index increased 5.51% and the MSCI EAFE index increased 2.23% in July. Typical discount rates for pension plans as measured by the Mercer Yield Curve decreased from 2.57% to 2.20%.

“With rates continuing to drop, additional pension funding relief is looking even more attractive to plan sponsors faced with large increases in contributions over the next few years. Unfortunately, debate continues in Congress over the next round of COVID-19 relief legislation, and at this point there’s no guarantee pension funding relief will be included this round,” Jarboe says.

Strong stock markets offsetting the impact of new all-time low interest rates provided a mixed result for October Three’s estimates. Its July 2020 Pension Finance Update says its model Plan A slipped 1% and Plan B tread water during July. For the year, Plan A is down 9% and Plan B is down 2% through the first seven months of 2020. 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 with a greater emphasis on corporate and long-duration bonds.

Brian Donohue, partner at October Three Consulting, notes that DB plan funding relief has reduced required plan funding since 2012, but under current law, this relief will gradually sunset. “Given the current level of market interest rates, it is possible that relief reduces the funding burden through 2030, but the rates used to measure liabilities will move significantly lower over the next few years, increasing funding requirements for pension sponsors that have only made required contributions,” he says. “2020 experience, if it persists, will not increase required contributions until 2022, compounding higher funding requirements due to the fading of funding relief.”

Donohue says there’s a chance plan sponsors will get more relief this year, “but at this point it’s too soon to say for certain.”

Michael Clark, managing director at River and Mercantile, says, “The House-passed bill, the HEROES Act, contained significant pension provisions that would provide almost all plan sponsors meaningful contribution requirement relief. However, the Senate’s HEAL Act (which still hasn’t passed) currently doesn’t contain any pension relief provisions. What will come of any reconciliation between the two chambers is anyone’s guess at this point.”

River and Mercantile’s Retirement Update – August 2020 says plans with larger equity allocations should see the largest improvements in funded status year-to-date, but a majority of DB plans are still likely down from the beginning of the year. Clark says discount rates for valuing pension liabilities are down almost a full 1% in 2020, which will increase liabilities anywhere from 10% to 15% for the average plan. “Only those plans with substantial allocations to liability matching assets that are well-funded will have fared well during the year. Everyone else is going to be faced with lower funded status numbers,” he says.