Defined benefit plan sponsors that review year-over-year changes in funded status may have seen a bit of a repeat of 2019 in 2020, with funded levels ending the year very close to where they started. However, the paths taken varied dramatically, with the negative market impact in the first quarter caused by the global pandemic more than wiped out in the last three quarters of 2020. The combination of another year of record equity market levels along with the decline in pension plan discount rates provided both challenges and opportunities for pensions. With 2021 upon us, we highlight three key areas of focus as plan sponsors think about enhancing their pension risk outcomes.
- Prior funding relief starts to wear away in 2021: Plans that are not fully funded on a market basis may see significantly higher contribution requirements over the next several years as funding relief starts to wear away this year, barring any additional relief from Congress. Liabilities used to calculate minimum contribution requirements are expected to increase as the impact of smoothing in higher historical interest rates are being phased out. This means that higher and more volatile contribution requirements are expected over the next several years. Plan sponsors looking for more stable contribution requirements should consider their ability to make discretionary contributions in the near term.
- Penalty for underfunding: Rising Pension Benefit Guaranty Corporation premiums have continued to be a pain point for many plan sponsors. In general, the penalty for being underfunded is 4.6% of the plan’s deficit in 2021, which has increased over the years from 0.9% in 2013. We believe organizations should continue to evaluate funding the plan to avoid this penalty.
- Funded status and risk posture: Contributions will improve a plan’s funded status and provide opportunities to de-risk the plan’s investments and improve the plan’s overall risk posture. How these contributions are allocated should be carefully considered.
- Although it is difficult to predict future market conditions, one thing we expect to continue to see is some form of volatility. Glidepath strategies are one of the primary ways for plans to take advantage of market volatility by locking in some gains as funded status improves. Diversification also continues to be important as equities reach new highs; a diversified allocation can help sustain a portfolio during future market corrections.
- For plan sponsors that question whether long duration bonds make sense in the current low interest rate environment, we recommend maintaining long duration investments to dampen the volatility of the plan’s funded status. Interest rates continue to be unpredictable, and in our view, a plan is likely to “win” regardless of the path of rates if the plan holds long duration investments. Waiting to adopt a long bond strategy 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.
Risk Transfer Strategy
There was a slowdown in risk transfer activity in 2020 as plan sponsors focused on the impact of the pandemic on their operations and costs of such activity. According to LIMRA, there were 15% less annuity contracts in the first nine months of 2020 versus 2019. We suspect that some plan sponsors canceled their risk transfer plans due to lower funded status observed during the year.
Considerations for future pension risk transfers include:
- Lump sums: Since interest rates remain low, one-time lump sum offerings that were common for the past few years are less attractive now — lower discount rates translate to higher lump sum values. Lump sums may still be effective at reducing pension risk and become more attractive if discount rates fall in 2021.
- 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. 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 made quickly.