Defined benefit plan sponsors have been grappling with the recent market volatility as the coronavirus outbreak has taken a toll on the markets. The following three market factors have spurred large swings in funded levels: 1) equity returns have reduced plan assets, producing a negative impact on funded status; 2) the decline in Treasury rates reduced plan discount rates and increased liabilities, producing a negative impact; and 3) credit spreads also affected plan discount rates, and swiftly widening spreads have caused lower overall liabilities, which has a positive impact.
Overall, funded levels have declined thus far this year for most plan sponsors due to volatility in the equity markets, and there are some natural questions that plan sponsors may be considering as they look ahead.
What Is Expected for Plan Financials?
If plans do not see a recovery in funded status by the end of the year, future contribution requirements would increase, but at a relatively slow pace, due to various funding relief and deferral mechanisms. Pension Benefit Guaranty Corporation (PBGC) premiums could increase significantly, up to $45 for every $1,000 of funded status decline. However, there are maximum premium amounts per participant that may apply and limit the premium increase amounts. The impact on balance sheets would likely be immediate, as funded status is marked to market on statements at fiscal year end. The income statement impact could be deferred over a number of future years, since most pension plans do not utilize marked-to-market pension expense recognition.
Will the CARES Act Help?
A couple of relief measures from the newly passed Coronavirus Aid, Relief, and Economic Security (CARES) Act could help plan sponsors through this difficult time.
- Contribution Delay: Cash contributions due during the 2020 calendar year can be paid by January 1, 2021 — with interest.
- Benefit Restriction Status: Plans may elect to use the plan’s adjusted funding target attainment percentage prior to January 1, 2020, to determine benefit restriction status for plan years starting in 2020. The relief could be beneficial for non-calendar year plans that may not have been able to pay lump sums or could be subject to temporary plan freezes during 2020.
Despite calls from pension advocates for additional longer-term funding relief such as PBGC premium adjustments or further interest rate smoothing, the CARES Act provides the above relief for the majority of employers. There is hope that additional relief could be provided in future stimulus bills.
What Type of Portfolio Adjustments Can Be Considered?
Staying on track with long-term strategies generally remains the prudent course of action for defined benefit plan sponsors. A carefully constructed glidepath is designed for volatile periods like the current one, and sticking with the plan will likely produce the best future outcomes.
If the glidepath policy does not call for re-risking (adding back equity) when funded ratios fall, taking re-risking actions now could create unintended consequences.
We would recommend continuing to follow normal rebalancing practices, but with careful assessment of transaction costs for illiquid segments or potential opportunities within policy that could add value. For example, plans should have seen Treasury bond holdings outperform corporate bond holdings, thereby producing an opportunity to trade expensive Treasury bonds for cheaper corporate bonds. Also, plans that need to shift assets back into equity may consider which segments are considered cheaper relative to fair values.
For plan sponsors that have yet to implement long-duration bonds into their strategies, there may be continued hesitation to make the switch to long bonds. Despite the absolute level of interest rates, with corporate spreads having widened significantly recently, an opportunity exists to buy corporate bonds at cheaper levels. Ultimately, short-duration or core bonds in portfolios are not expected to produce excess returns over liabilities, and long-duration bonds are expected to help reduce volatility in funded status, similar to what we have recently observed.
Are Pension Risk Transfers Still an Option?
As pension risk transfer activity has been growing over recent years, there are likely a number of plans in the process of offloading liabilities through a plan termination or partial settlement. From an investment perspective, it is a best practice to restructure the portfolio as soon as a decision is made to start the 12-18 month termination process.
Plans that restructured their portfolios prior to 2020 are likely significantly insulated from recent market swings, which means they are more likely to continue to the termination process.
These portfolios would hold a combination of cash pegged for locked-in, lump-sum values or long-duration bonds pegged for annuities that are sensitive to interest rates. Generally speaking, bond values should move in tandem with annuity values, though there could be some basis risk if the portfolio credit quality differs from the insurer’s cost. Plans that have yet to restructure the portfolios may consider delaying the termination until market conditions improve and the cost to terminate gets back to an affordable level.
Plan for the Unexpected
It is difficult to predict how plans will be positioned at the end of the current year, given that many external factors contribute to the ultimate path.
As always, having a financial plan in place for the pension and a roadmap to navigate various environments may help to prepare for adverse scenarios like the one we are currently experiencing.
For more information, contact Kimberlene Matthews, Director of Pension Solutions, at firstname.lastname@example.org.