For defined benefit plan sponsors, 2019 illustrated how difficult it is to predict the market environment, its impact on pension plans, and the importance of preparing for all outcomes.
The combination of another year of record equity market levels along with the sharp decline in pension plan discount rates provided both challenges and opportunities for pensions. With 2020 upon us, we highlight three key areas of focus as plan sponsors think about enhancing their pension risk outcomes.
Despite not having the benefit of tax reform to spur discretionary contributions as we saw back in 2018, there are still reasons for plan sponsors to consider additional plan funding and, importantly, planning for the future state of defined benefit plan measurements.
We believe plan sponsors are at a point where their current contribution decisions could influence whether they will see more volatile versus more predictable contribution requirements in future years.
Consider the following factors that could affect near-term outcomes:
- Higher minimum requirements — Plans that are not fully funded on a market basis may see significantly higher contribution requirements over the next several years as funding relief nears its end. Liabilities used to calculate minimum contribution requirements are expected to increase as the impact of smoothing in higher historical interest rates is being phased out. This means that higher and more volatile contribution requirements are expected over the next several years. Plan sponsors who are looking for more stable contribution requirements should consider reviewing multiyear projections with their actuary and budget for contribution amounts that the plan sponsor can afford sooner rather than later.
- Penalty for underfunding — Rising Pension Benefit Guaranty Corporation premiums will continue to be a pain point for many plan sponsors. Although we saw the last of the scheduled legislative increases in premiums in 2019, the premium rates continue to increase with inflation. In general, the penalty for being underfunded is 4.5% of the plan’s deficit in 2020, up from 4.3% in 2019 and 0.9% in 2013. Further, with sharp interest rate declines in 2019, the deficits are growing as liabilities climb higher. We believe organizations should continue to evaluate funding their plans to levels that enable them to avoid this penalty.
- Funded status and risk posture — Contributions should improve a plan’s funded status and provide opportunities to de-risk the plan’s investments and improve the plan’s overall risk posture.
Over the last couple of years, we have seen liability-driven investment strategies such as glidepaths or long-duration investing pay off in a volatile equity and interest rate environment. In particular, in 2019, a year in which corporate pension plan discount rates fell over 100 basis points, long-duration fixed-income strategies significantly outperformed intermediate duration strategies. Many plan sponsors are evaluating where to take investments from here. Consider the following:
- With the expectation for market volatility to continue, it is especially important to consider inclusion of less traditional investments, such as real assets or diversified credit strategies. With equities seeing all-time highs in 2019, a diverse portfolio is expected to outperform one with just traditional equities and bonds during market corrections.
- Some plan sponsors hesitate to adopt long-duration investment strategies during low interest rate environments. The new “normal” for interest rates has become difficult to predict given global demand for US bonds, and as such we do not recommend trying to time the markets when it comes to aligning fixed income investments with the plan’s liabilities. Waiting to adopt may cost the plan additional yield and return if rates remain at current levels or decline further. Importantly, in most cases, a plan’s funded status will still benefit from rising interest rates due to a more significant reduction in liabilities than assets.
- Glidepath strategies shift assets out of equities into liability hedging fixed income as funded status improves. For plans that currently maintain static allocation, we recommend adopting a well-executed glidepath strategy. Some plans may find themselves getting an opportunity to de-risk with additional contributions into the plan as funding relief wears off. Having a plan for those investments should reduce the likelihood of falling backwards.
Risk Transfer Strategy
Risk transfer strategies continue to be a point of consideration for reducing the overall size and exposure of a pension plan. A number of factors, however, may affect the risk transfers effectiveness.
- Lump sums: Since interest rates sharply declined in 2019, one-time lump sum offerings that were common for the past few years are less attractive for plan sponsors for 2020 — lower discount rates translate to higher lump sum values. Lump sums may still be effective at reducing pension risk and become more attractive if rates continue to fall in 2020.
- Termination or hibernation: Many plan sponsors with closed or frozen plans have reached a point where they are deciding whether near-term termination of the plan is preferred versus maintaining the plan through a hibernation strategy. In our experience, plans with a near-term termination objective see improved outcomes with customized investments (especially fixed income) that can be adjusted quickly as the plan navigates its termination timeline, which can be 12–18 months once the process is started. We recommend plans with longer-term termination objectives monitor the funded status frequently to track how far off the plan is from the goal so that adjustments to the strategy can be reflected quickly.
2019 proved to be an interesting year for pension plans, with strong positive returns for equities, fixed income, and pension plan liabilities.
We think it is imperative in 2020 to closely monitor market conditions and to carefully consider the impact contributions and risk transfer strategies may have on a pension’s funded status.
This oversight and planning can help confirm an appropriate asset allocation can be put in place quickly to meet your goals for your pension plan.