Pension relief paves way for more de-risking

The $1.9 trillion American Rescue Plan Act signed by President Biden contains the most important changes in single employer pension funding relief rules since the introduction of the Pension Protection Act in 2006. 

What is changing?

The new rules enforce two key changes in how minimum required contributions (MRCs) are calculated. 

Firstly, the Act extends and enhances the Interest Rate Stabilization mechanisms brought in over the last decade (specifically, Moving Ahead for Progress in the 21st Century Act (MAP-21) in 2012, the Highway and Transportation Funding Act (HAFTA in 2014) and the Bipartisan Budget Act (BBA) in 2015).

These measures allow a plan to discount its liabilities using rates based on a 25-year average of interest rates instead of more current ‘marked to market’ rates. This stabilization mechanism is further enhanced under the Act by introducing a 5% floor on the 25-year rate averages. 

Taken together, these measures will have the effect of increasing the assessed funded status of plans for MRC calculation purposes, initially, by ~30-40%, depending on a plan’s current funded status, relative to more marked-to-market measures. 

Similar to the previous relief measures, the new rules will apply a corridor to the 25-year smoothed rates (subject to the floor), starting at +/-5% for the next several years, moving to +/-10% in 2026 and subsequently increasing by 5% each year until reaching  +/-30% in 2030. As a result, the relief measures are scheduled to wear away at a much slower pace than previous legislation.

Secondly, the Act also extends the Shortfall Amortization Period for MRC purposes from seven years to 15 years, thus lowering yearly MRCs where applicable. Additionally, this extended amortization period can be applied retrospectively as prior year shortfall amortization calculations can be reset to zero. 

What does it mean?

For most plans, we believe the major impact of the new rules will be to significantly reduce near-term MRCs, effectively deferring them into the future. For some well-funded plans, it can mean no projected MRCs at all for the foreseeable future. 

Figure 1 below shows comparative projected minimum contributions for a hypothetical $100m plan that is 85% funded (on a GAAP basis) under the original PPA funding rules, the previous relief measures and the new 2021 relief rules. From the chart we can see the effect of the new relief in pushing minimum required contributions out several years out into the future and lowering the overall burden in the near to medium-term.

Figure 1*: Near-term minimum required contributions will be significantly reduced and deferred into the future

The extension and enhancement of the interest rate stabilization measures will potentially also serve to provide greater smoothing of contributions under adverse tail-risk scenarios as shown in the further example below, which assumes. 

Figure 2: Enhanced relief measures are also powerful in smoothing contributions under adverse tail risk scenarios

An opportunity to take risk off the table?

While the new rules will reduce the near to medium-term contributions, we believe that the measures will nonetheless provide a meaningful opportunity for plan sponsors to pursue a lower volatility and higher-certainty return strategy. This is because there will now be a longer investable time horizon, before MRCs become as much of a consideration again. This will allow plan sponsors extra time to close their deficits, meaning they can, in our view, adopt a lower return ‘slow and steady’ strategy to close their funding gaps.   

Figure 3 shows actual disclosed target returns for large corporate defined benefit plans. Many sponsors aim for returns in the range of 6% to 7% p.a. However, we calculate that only a 5% annual return is required to achieve full funding over 15 years for a sample plan that was 85% funded at the end of December 2020 and which has an ongoing accrual rate equal to 1% of liabilities. (Fees and other expenses could impact the target return projections noted herein.) This return further reduces to 4% p.a. for a plan which is ’frozen’ with no ongoing accrual.

Figure 3**: New funding relief rules can present a de-risking opportunity

Achieving more with fixed income – duration and cashflow matching

Should plan sponsors take the opportunity to allocate more to fixed income, we believe it will become imperative to seek to achieve a close match to liability cashflows. 

This is necessary in order to control funded status risk and volatility. To date, fixed income allocations have generally focused on increasing duration. However, as corporate defined benefit pension plans are rapidly maturing, many will face large outflows in the coming years to pay benefits, and given the new rules, potentially reduced inflows from contributions. They will need to focus more on liquidity and cashflow management. 

Moreover, for better-funded plans, the new relief may also provide an opportunity for plan sponsors to seek to mitigate any and all future contributions into their plan. However, this brings new considerations as the focus will need to be on maximizing the certainty that the current pool of assets will be sufficient to meet all the future liabilities. This will involve managing fixed income allocations and supplemental hedges in a more solvency-orientated way, locking-down and immunizing all liability risks.

Key conclusions

We conclude that the key advantage of the additional relief measures is that plan sponsors will have greater flexibility on the size and timing of contributions to their plans and will be able to revisit the strategic balance between cash funding and investment returns in closing their deficits. 

Also, as many plan sponsors are already on a well-established de-risking path, we believe that they will be able to use the change in funding rules and extended time horizon to further reduce funded status volatility. This can be achieved by further shifting pension assets out of equities into liability-matching fixed income strategies. Of course, some may alternatively use funding relief to re-risk their plan asset allocation, but we believe this will be the minority.  

What should you do now?

Most important will be to understand what the new rules will mean for your plan and work with your actuaries to understand your updated contribution requirements.  Beyond this, we believe now is a great opportunity to review all your key strategic policy levers in managing the cost and risk of your pension programs, such as funding, investment and liability risk management.  

* Figure1: Insight estimates. Note this is a hypothetical illustrative example based on the following assumptions: a $100M Plan with a funded status of 85% on a GAAP basis with a 1% ongoing annual accrual of benefits. Central Investment return scenario is 4% annually over 10 years and Low Investment Scenario is 2% annually over 10 years. Actual returns could be different than what is provided herein. Additional simplified funding assumptions: Plan uses 24-month smoothing to determine the Actuarial Value of Assets, has $0 Pre-funding balance, and no existing Shortfall Amortization bases. Future discount rates changes follow the forward curve. Using FTSE AA curve as of December 31, 2020 gives a single equivalent rate of 2.25% for GAAP PBO purposes and duration of 13 years. 

** Figure 3: Returns targeted from Top 100 actual plan sponsors sourced from IRS, FTSE., Data as of December 31, 2020. Required net investment returns are Insight calculations. Note this is a hypothetical illustrative example based on the following assumptions: modeling results assume no mandatory or voluntary contributions to the Plan are made. Plan is assumed to be 85% funded on a GAAP basis as of December 31, 2020 basis and 50% interest rate hedge ratio. Future discount rates follow the forward curve. PBO calculated based on FTSE AA curve as of December 31, 2020, single equivalent rate 2.25% and duration of 13 years. Results are illustrative and will vary depending on individual Plan’s situation.

Kevin McLaughlin is Head of Liability Risk Management – North America at Insight Investment. Insight Investment is a global leader in fixed income and liability driven investment (LDI) solutions. Our services include ultra-short, core and long duration income, custom liability benchmarks, liability ‘completion’, cashflow driven investments and self-managed ‘hibernation’ strategies. Our mandates are supported by our client service and solutions teams who seek to work in close strategic partnership with our clients and their advisors. 

Nothing herein represents actuarial, investment, tax or legal advice. Plan Sponsors and Fiduciaries should seek their own independent advice. Please note: any forecasts or opinions expressed herein are Insight Investment’s own as of the date of publication and are subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results.