Is the flexibility worth the risk?

The funded status of the average corporate pension plan has increased by approximately 10 to 15 percent in 2021, elevated by a roaring stock market and modestly higher interest rates. These improvements have prompted several plan sponsors to de-risk their asset allocations into Liability Driven Investing (LDI) strategies, further fueled by a strong consensus that equity markets are overvalued.

However, certain sponsors are headed in the opposite direction and are instead considering re-risking in the search for higher returns, in light of the contribution flexibility afforded by the American Rescue Plan Act (ARPA) and the Infrastructure Investment and Jobs Act. While every corporate pension plan sponsor has unique objectives and circumstances that should be taken into account when setting a long-term investment strategy, re-risking allocations and deferring contribution amounts may delay or jeopardize many plans from reaching their long-term goals, typically full termination of the plan.

Passed in March of 2021, ARPA included provisions that reduced upcoming contribution requirements for single-employer pension plans. ARPA allows for higher-than-current interest rates, basing rates on 25-year historical averages to calculate funding liabilities. In November, the Infrastructure Act further extended the usage of these higher rates from 2029 to 2034. As rates remain near historic lows, this reduces liabilities – and therefore, associated contribution minimums. In addition, the amortization period for unfunded liabilities was extended from 7 years to 15 years under ARPA. This relief will fade over time, so the legislations are intended to only defer contributions.

The ARPA provisions were introduced in the peak of the pandemic when funded statuses had taken a nosedive in early 2020. Income Research + Management’s Funded Status Monitor reports show that the average plan funded status fell over 10% in the first quarter of 2020 alone.

The rationale from lawmakers was that this relief would allow sponsors to retain more cash for their pandemic-strained core operations while also providing “income” for the federal government. Lower pension contributions and associated tax-deductions from plan sponsors were used to offset other spending initiatives within ARPA. However, by the time ARPA was passed, funded statuses had returned to pre-2020 levels and arguably, most sponsors did not need the additional reduction in contributions.

Plan sponsors also continue to benefit from inflated interest rates and funding relief allowed from prior legislation, beginning with Moving Ahead for Progress in the 21st Century, passed in 2012. Many sponsors have made discretionary contributions above stated required minimums for the past decade. This cohort includes sponsors committed to reaching the end stage of plan termination and off-loading their pensions from corporate balance sheets.

In light of the culmination of funding relief, some advisors suggest seeking higher returns through higher growth asset allocations, with the intent of closing funding deficits through investment gains rather than cash contributions. Because many investment professionals believe equities may be overvalued, these recommendations often center around illiquid alternatives such as private equity, hedge funds, and infrastructure investments that may offer better compensation over the long term. However, this stark risk-on decision should be weighed holistically against the sponsor’s desired time horizon to reach the plan’s end stage. Simply put: With more risky assets, the likely range of ending funded statuses and required contributions has widened.

Most sponsors have a final goal of terminating their pension plan and fully off-loading the plan’s liabilities to an insurer. Market dips may extend the time horizon to reach termination as a higher share of growth assets leaves the funded status more exposed to interest rate and market moves.

If markets do cooperate, will the plan sponsor be able to move quickly enough to shift the strategy, or possibly terminate, to capitalize on funded status gains? It may be costly to quickly liquidate assets, especially if assets are tied up in illiquid alternatives. Also, the governance structure for many plans does not allow for nimbleness in decision making. Often, investment strategy decisions require committee and board approvals. This may be alleviated by granting a consultant or outsourced chief investment officer (OCIO) provider full discretion, especially in terms of capturing tactical views.

The higher upside potential from re-risking comes at the cost of balance sheet volatility and potential for higher PBGC premiums. The increased funded status volatility would be directly reported on the balance sheet; financial accounting liabilities are subject to current market-based interest rates, not the higher rates allowed under ARPA and the Infrastructure Act. PBGC variable-rate premiums are also based on non-inflated discount rates. So, a year with a bad market downturn could result in reporting a higher funding deficit as well as paying a higher PBGC premium.

If these risks are beyond the sponsor’s tolerance, LDI may provide a more prudent and measured path forward so as not to put recent funded status gains in danger. Many plans with more traditional asset allocations can reduce funded status volatility by increasing allocations to fixed income and/or increasing the duration of their fixed income portfolio. A custom LDI strategy can be constructed to better align asset and liability performance as markets evolve. A glidepath can also be added in investment strategies to systematically de-risk as funded status improves, further muting the market bets taken.

It is timely for many plan sponsors, especially those with fiscal years corresponding with calendar years, to revisit investment and funding strategies at the start of the new year. Client circumstances and objectives will influence a sponsor’s decisions around whether to make discretionary contributions as well as re-risk. For example, if a pension plan is a smaller part of the balance sheet or the sponsor has strong cash availability, the sponsor may prefer trying to earn their way out of the plan’s deficit. The plan may be too small for its funded status variability to impact the sponsor’s overall balance sheet, and/or the sponsor may not be concerned about meeting future contribution needs.

On the other hand, if a company wishes to preserve funded status gains, prefers predictable contributions, and/or the pension deficit is meaningful in terms of overall company financials, utilizing LDI and de-risking now will provide more stability in terms of contributions and funded status. Ultimately, when crafting a plan’s investment strategy, a sponsor should conduct an asset-liability study and partner with consultants and managers that they trust.

Theresa Roy, FSA, EA, CFA is SVP, Investment Product Specialist, Income Research & Management.

IR+M Funded Status Monitor Assumptions: Detailed methodology and assumptions for the IR+M Funded Status Monitor can be found at: https://www.incomeresearch.com/wp-content/uploads/2021/01/IRM-Funded-Status-Monitor-2021.pdf As of 1/3/22. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.