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The title of our 2016 annual review report was “On the Move” as we noted many plan sponsors were taking proactive measures with respect to their plans and funded levels may have been poised to rise given the expectation of pro-growth policies and higher interest rates. Much of this played out over the past six months, although without the rise in interest rates. In this brief note we provide our observations on the first half of 2017 and what we might expect over the final six months of the year.
Funded levels have been on the move in 2017, albeit only marginally. We estimate the aggregate funded status of the US corporate defined benefit (DB) system has inched up to 83% as of the end of June from 81% at the start of 2017, despite the fact that long-term interest rates have fallen year-to-date (YTD). Several factors have contributed to the marginal improvement in 2017:
A. Many plans are likely near their annual long-term expected return on assets (EROA) assumption only halfway through 2017: Resilient equity markets, both in the US as well as abroad, combined with positive fixed income returns from lower YTD interest rates and tighter credit spreads have contributed to strong asset returns YTD. The average EROA assumption in 2016 for US corporate DB plans was 6.9%. Based on the aggregate corporate DB asset allocation in the S&P 500 as of the end of last year, we estimate actual YTD returns in 2017 of around 6% - 7%. Obviously individual plan results will vary based on the applicable asset allocation employed. Nonetheless, in general, actual asset returns in the first six months of the year have helped to boost funded ratios as some plans are likely already at their long-term return target.
B. Robust voluntary contribution activity continues as sponsors focus on minimizing PBGC variable-rate premiums and potentially getting ahead of anticipated corporate tax reform. Our previous work indicated 2016 was the strongest year for contributions in the US corporate DB space since 2013, despite the fact that many plans still have little to no mandatory contribution requirement given funding relief enacted in recent years. We forecast a roughly 10% increase in total contributions in 2017 based on our analysis of expected contribution disclosures in sponsor annual reports as filed with the Securities and Exchange Commission.1 In our discussions with clients, minimizing PBGC variable-rate premiums continues to be a catalyst for voluntary contribution activity, as well as in some cases a desire to reap a larger tax deduction if potential tax reform results in a lower corporate tax rate in future periods. As discussed below, several sponsors have sourced their contributions by raising debt through the capital markets, a topic we have written on several times over the course of the past year.2
C. Interest rates in mid-June touch their lows for the year. Offsetting the positive aspects noted above has been yet another decline in long-term interest rates, despite the fact the US Federal Reserve has raised short-term interest rates twice this year. The yield on the Moody’s Aa, a popular proxy for liability discount rates, declined around 20 basis points from the beginning of the year through the end of June. For a plan with a liability duration of around 10 – 12 years, this decline would, by itself, likely increase gross pension liabilities by around 2% - 2.5%, placing downward pressure on funding levels.
Higher PBGC flat and variable-rate premiums continue to drive corporate behavior with respect to their DB pension plans. During the first half of 2017 we observed a number of corporate actions which were likely influenced by a desire to reduce the overall expenses of the plan. Several examples include:
A. More and more sponsors recognizing the economic benefits of borrowing to fund their DB pension plans. FedEx, Verizon, Delta Air Lines and DuPont all executed borrow-to-fund transactions in the first half of 2017. This followed several other notable transactions in 2016. A common question we hear around this strategy is how large a contribution should sponsors make? In a theoretical sense, one could make the argument that the correct answer is up to the point where PBGC variable-rate premiums are eliminated. In practice, it appears many have used this strategy to make an incremental contribution as a way to get up their glide path. In the table at the end of this note we have summarized some of the more salient details of a number of the larger debt issuances over the past twelve months where the sponsor has used some or all of the proceeds to contribute to the DB pension plan. Included in the table is an illustrative “pro forma” impact to funded status from the contribution.
B. Annuitization, particularly for small balance retirees, remains a popular topic. Sears, Accenture, and Hartford Financial Services Group all executed notable annuitization transactions in the first half of 2017. As with other risk transfer actions we have observed over the past several years, a desire to reduce plan expenses, in particular the aforementioned PBGC flat rate premiums, appears to be a motivating factor in many of these transactions. Since PBGC flat rate premiums are paid on all participants irrespective of the size of their accrued benefit, the “cost” of keeping low balance participants in the plan may be seen as being prohibitive by some. In the case of Sears, the company transferred $515 million of liabilities across approximately 51,000 retirees, which equates to an average pension value of roughly $10,000 per participant. We expect more sponsors may target risk transfer for similar low balance retirees.
We expect many client conversations in the second half of 2017 to mirror those of the first half of the year: concerns around equity valuations, the outlook for long-term interest rates, contribution strategies (in particular around borrowing to fund), and risk transfer. As if that is not enough for sponsors to chew on, a pending accounting rule change may also lead some plans to review the impact of their risk taking tolerance.
Earlier this year the FASB finalized a new rule regarding how plan sponsors present net periodic benefit cost in their income statements.3 Among other items, the new rule requires an employer to report the service cost component of pension expense in the same line item of the income statement as other compensation costs arising from employee services during the period. Other components of pension income/expense, such as interest cost, EROA income, and amortization of actuarial gains and losses, would be reflected separately outside a subtotal of income from operations, if one is presented.
While not changing the recognition or measurement of pension obligations, shifting where on the income statement different components of pension income/expense are reflected may potentially impact how plan sponsors view their pension plan. In particular, some plans may maintain a relatively high exposure to equities or other asset classes with high long-term expected returns to support a relatively high EROA assumption, which offsets pension expense components. If EROA income is no longer reflected in operating earnings, and if a sponsor is focused on operating income as a key performance metric, then that might affect how a sponsor considers the impact of maintaining exposure to more return seeking assets, or shifting to more of a liability hedging asset allocation.
On the other hand, under the new rule, EROA income would still be a component of net income and, consequently, earnings per share. Given that many sponsors focus on these financial metrics, changing where EROA income is reflected on the income statement might not affect their views on the impact of a pension’s asset allocation, investment strategy, and risk taking tolerance.
The determination of how this change might affect sponsors’ views on their plans may differ from organization to organization. In our conversations with clients a number have indicated they are still formulating their thoughts on this change. With this new rule generally effective for fiscal years beginning after December 15, 2017 (although early adoption was permitted), we expect clients may spend more time on this topic over the remaining six months of the year.
Source: Company Annual Reports and releases; analysis as of 6/30/2017
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