As a result of corporate tax reform through the Tax Cuts and Jobs Act of 2017, there was increased contribution activity during 2017 and year to date (through September 2018), with a large number of organizations making discretionary contributions to their defined benefit plans.
Companies generally have 8.5 months after the plan year ends to contribute for the prior tax year, meaning September 15, 2018, was the last day for plan sponsors to make contributions for the 2017 tax year.
We remind plan sponsors to be mindful of their risk posture in the wake of these extraordinary contributions. They should also consider how to allocate these assets and position the overall portfolios to meet their objectives. In this Pension Risk Spotlight, we offer considerations we believe are important for efficiently and effectively applying these contributions toward plan health.
Starting with perhaps the most obvious, as of September 30, 2018, equity markets have continued to push all-time highs. For plans with significant equity exposure, this has been a positive for funding ratios. At the same time, interest rates have continued to push higher as well. This could be a net positive for underhedged pension plans since liabilities have shrunk in response to higher discount rates. This presents an opportunity for many plans to reduce risk by adding long-duration fixed income allocations as part of a de-risking strategy.
Finally, a spate of extraordinary contributions has improved the plan health (as measured by funding ratio) of many corporate defined benefit plans.
Considerations for Plans with Static Allocations
We believe it is healthy to examine pension risk preferences periodically. In light of the factors that have recently worked in favor of pension plans, we think it is a good time to evaluate protecting some of the gains through a de-risking strategy. For plans with static allocations, we believe there are three important considerations:
- Consider a glidepath — an asset allocation strategy that increases the allocation to liability hedging assets from return-seeking assets as funding status improves.
- Direct funds to long-duration fixed income to reduce funded status volatility due to changes in interest rates.
- Consider diversifying return-seeking assets if the plan is still underfunded.
Considerations for Plans on a Glidepath
For plans already on a glidepath, we believe appropriate measurements will help determine if triggers have been breached and a change in asset allocation is warranted. In addition, for plans invested through an outsourced pension management provider, plan sponsors should verify the new funds are invested within the constraints of the plan’s investment policy statement and agreed-upon strategy.
Considerations for Well-Funded Plans
For well-funded plans considering termination, it can be important to reach out to experienced pension risk transfer consultants to determine if the plan is positioned well for a liability transfer before the plan hits its fully funded position. As contributions to a pension plan are notoriously difficult to draw back to the plan sponsor, the risk of overfunding the plan may result in an ineffective use of cash.
If your plan has seen an improvement in its funded ratio, we suggest considering a de-risking plan such as a glide path or an allocation to liability-hedging assets. This could:
- protect the extraordinary contribution made to the plan, potentially reducing the magnitude of a future contribution if markets experience a downturn;
- reduce the volatility in the plan’s funded status and on the corporation’s balance sheet; and
- reduce the volatility of the variable rate Pension Benefit Guaranty Corporation (PBGC) premium, especially since many plan sponsors have made contributions to reduce the effect of the rising variable rate PBGC premium. Maintaining market risk (through return-seeking assets) in the plan may increase the likelihood the plan sponsor will have to pay the hefty variable rate PBGC premium if and when markets experience a downtown.
Overall, we think recent improvements to pension plan funded status create a need for sponsors to carefully evaluate their risk postures. We recommend working with a plan consultant, investment manager, and actuary with experience in this area to help determine specific steps to take so pension plans can meet their objectives.
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