Despite vastly improved funding, corporate pensions still face headwinds

The aggregate funding levels for corporate single-employer defined benefit pension plans is tracking at highs not seen since the 2008 financial crisis.

Mercer recently estimated the aggregate funding level of S&P 500 sponsors at 91 percent. Milliman’s Pension Funding Index, which analyzes the funded status of the 100 largest pensions, put the funded ratio above 93 percent at the end of July.

“Single-employer plans have had a rocky decade since the crisis, but they are much healthier today,” Alex Pekker, a senior investment director at Cambridge Associates’ San Francisco office, told BenefitsPRO.

“Big improvements have really come over the last two years, with strong equity markets, rising discount rates, and increasing contributions—but contributions have been the real driver,” he added.

Data from BlackRock shows pensions’ aggregate funded level cratered to near 70 percent in the wake of the 2008 financial crisis. By the end of June in 2012 it had crept back up to 76 percent. In 2007 it hit 110 percent.

Increased discretionary contributions to plans—money sponsors infuse in plans beyond what is statutorily required by the Pension Benefits Guaranty Corp.—were seen before passage of the Tax Cuts and Jobs Act last December.

But the law’s provision that slashed the corporate tax rate from 35 percent to 21 percent has encouraged a further volley of contributions, as corporations have until September 15 to write off contributions at the previous corporate rate.

Pekker and other consultants expect more sponsors to announce contributions as the September 15 deadline draws closer.

But in spite of those contributions, and today’s higher aggregate funded status, Pekker cautions sponsors against several headwinds in the immediate and near-term future that could create what he calls “contribution regret,” wherein sponsors fail to hold onto funding gains after investing valuable assets to shore up their obligations.

“If sponsors are not adjusting their investment strategy and devising a contribution strategy going forward, they may not be able to hold on to those gains,” said Pekker. “Contribution strategy should go hand-in-hand with investment strategy.”

Elapsing opportunity for pension smoothing

Rising premium requirements to PBGC, which are pegged to funded status, have encouraged aggressive contribution strategies over the past decade.

Congress has helped ameliorate sponsors’ pension stress through several provisions since 2012.

The Moving Ahead for Progress in the 21st Century Act, otherwise known as the Highway Bill, allowed sponsors to apply a higher discount rate to plan liabilities by using the 25-year average of the corporate bond yield within certain corridors. Previously, plans were allowed to smooth discount rates over a 24-month period, courtesy of the Pension Protection Act of 2006.

Using the longer-term average allowed for a higher discount rate, which lowered the cost of future liabilities and thus decreased annual funding requirements. The Bipartisan Budget Act of 2015 extended the use of the 25-year corporate bond yield average through 2020.

But as Pekker explained, each year the 25-year history of corporate bond yields passes brings those historical yields inline with more recent yields.

“Over time you are not benefiting as much from the 25-year average, as you take out the yields from 25 years ago,” he said.

By 2020, sponsors can expect the discount rate to revert back to the 24-month average. “That will make funding rates look more like mark to market, which will increase liabilities, and require additional contributions to plans,” said Pekker.

Updated mortality tables expected to increase cost of liabilities

The Treasury Department will begin requiring updated mortality tables to determine minimum funding requirements for 2018 pension plans. Sponsors will have the ability to defer implementing the tables until 2019.

A recent paper from Cambridge Associates projects updated tables will increase minimum required contributions by an average of 4 percent to 5 percent annually. Cambridge advises more than 140 pension clients with $172 billion in total assets under advisement.

In past years, sponsors have benefited from stagnant mortality tables—the Society of Actuaries updated its mortality table, which is used by the IRS, in 2015. The last update had been in 2000.

Going forward, IRS expects to use annual updated mortality tables. That will create a new wrinkle for pension sponsors, but Pekker doesn’t expect the volatility to be unmanageable, as large sponsors use annual tables for other areas of their accounting.

Each plan a snowflake

The good news in improved aggregate funding status is just that—good news.

But complacency on the part of sponsors would be ill advised. The improvements realized over the past two years could go away as quickly as they came, said Pekker. The challenge now facing sponsors is holding on to the gains.

That will leave pension governing committees with a range of considerations specific to individual plans. Pre-packaged, off-the-shelf strategies will be of little use for many sponsors.

“We firmly believe each plan is as unique as snowflake,” said Pekker. Participant demographics, different plan structures—an open or a frozen plan, for instance–and whether plans pay retirees in lump sums are just a few factors for sponsors to weigh when determining and investment and contribution strategy moving forward.

“There is a range of governance structures and how sponsors approach their pensions,” he said. “Some are more sophisticated, and others may not have sufficient bandwidth do develop a contribution strategy. In some cases a CFO has a set budget for contributions, and investment strategy comes second.”

The impact of pensions on the health of businesses and corporations is also case specific. For some sponsors, pensions may be a smaller part of the overall balance sheet. In the case of others, liabilities are more expensive than their market capitalization.

Determining a contribution strategy going forward should be considered as part and parcel to the overall business strategy, said Pekker. “Sponsors need to do a thorough analysis on which pension objectives fit their overall corporate needs.”

For the best funded plans that now have the opportunity to entertain de-risking strategies, there isn’t a one-size-fits all solution. Using a liability driven investment strategy, or LDI, which deploys less volatile assets to produce returns to keep up with the cost of future liabilities, has its own potential pitfalls, depending on a sponsor.

“Even for plans that have become fully-funded, complete de-risking is not necessarily the right approach. It’s important to have some growth assets even when fully funded,” he added.

Then there is the question of whether Congress will leave corporate pensions alone. Extending smoothing is not inconceivable, particularly if there were a dramatic downturn in the markets, said Pekker.

And while lawmakers appear to have heard the strains of sponsors in the face of repeated hikes to PBGC premiums over the past decade, Pekker notes that premiums will still be pegged to increased in inflation.

“I’m not sure how much more pain sponsors can take. If PBGC premiums were to increase at a faster rate than inflation, it would lead to more risk transfers, and the further demise of the single-employer pension system,” he said.