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A: 2016 was an up and down year for many DB plans. Early in the year, long-term interest rates and equities fell simultaneously, contributing to a decline in funded levels. By our estimate, aggregate funded status at one point fell by as much as 5% during 2016, leaving plans trying to recover over the course of the rest of the year. The subsequent rise in interest rates and US equities post the US presidential election helped to increase funded levels, but we estimate that in aggregate, US DB plans within the S&P 500 index are about 82% funded on a GAAP PBO basis, essentially right where they began the year. While the recent rise in funded levels is welcomed, many plans have only clawed back the decline in funded status they saw earlier this year. Obviously, the results of individual plans will vary based on such factors as asset allocation, contribution activity and whether the plan is still accruing new benefits.
A: Several factors have held back further improvement in funded levels. First, while yields on 10- and 30-year US Treasury bonds are now above 2015 year-end levels, long-term investment grade corporate bond yields were slightly lower at the end of 2016 as credit spreads tightened. Since US corporate DB plan liabilities are valued for accounting purposes on high-quality corporate bond rates, some plans will likely use a similar discount rate to the one used at the end of 2015. This means they may not see the reduction in liabilities that would occur if they were able to increase their discount rate. Second, many plans are cash flow negative, meaning they are paying out more in benefit payments than they are receiving from contributions. This is partly due to the natural maturation of these plans as more participants move into retirement status, but is also influenced by the continued trend of risk transfer through lump sums and annuitization, which can contribute to increased outflows. When a plan is underfunded, like many are today, being cash flow negative places downward pressure on funded ratios. Finally, while US equities had an excellent year, other asset classes did not perform as well. Some plans may see actual returns fall below their long-term expected return on assets assumption.
Source: Moody’s; Thomson Reuters., as of December 31, 2016.
A: The first thing to keep in mind is the improved outlook from only a few short months ago. Around late October many plans were facing notably higher deficits, with some likely having seen year-to-date declines in funded ratios of around five percentage points or more. For their sponsors, this would have meant recognizing higher balance sheet liabilities at year-end 2016 and potentially higher pension expense in 2017. They also could have incurred higher variable-rate premiums owed to the Pension Benefit Guaranty Corporation, otherwise known as the PBGC, and, potentially, higher contributions. Indeed, some companies that had previously moved to a mark-to-market pension accounting framework had disclosed during 3Q earnings releases and conference calls that, at that time, they anticipated recognizing material pension expenses in 4Q 2016 due to year-to-date declines in funded levels. The improvement over the past few months has likely greatly diminished these potential expenses and balance sheet adjustments. At year end, some plan sponsors may have reported a year-over-year improvement in funded status that could provide a tailwind to many aspects of financial reporting, which would be a welcome turn of events heading into 2017.
A: Yes. The higher flat rate premiums have influenced plan sponsor views on the merits of moving some participants out of the plan through risk transfer actions. The higher variable-rate premiums have also influenced contribution strategies as plan sponsors proactively work to minimize deficits. Consider that the PBGC’s recently released 2016 annual report showed a 12% increase in flat rate premium income in fiscal year 2016 while variable-rate premium income increased 81%. These premium increases have been a popular topic of conversation with clients and have led many of them to take proactive steps to try to mitigate these ongoing costs.
Source: Pension Benefit Guaranty Corporation Annual Report; Goldman Sachs Asset Management; as of December 2016.
A: We believe that much of the recent rise in equity values and interest rates seems to be linked to an expectation that many of the new administration’s policies will lead to lower taxes and higher growth and inflation. If those policy actions play out as contemplated then, yes, we could see a positive environment for corporate DB plans as equity values and interest rates may continue to march higher. This would likely contribute to rising funded ratios and would be the optimistic scenario for corporate DB plans.
On the other hand, the financial markets appear to be pricing in policies that have yet to even be formally proposed. If some of these policies are not enacted, or are altered from what is currently anticipated, then some of the rise in equity values and interest rates could possibly reverse. That would obviously be a pessimistic scenario for DB plans, placing downward pressure on funded status and unwinding some of the recent improvement.
A: In some respects, plan actions will be predicated on how the environment evolves, as we just discussed. But conversely, we believe sponsors may take some actions irrespective of the path of the economy or the financial markets.
In the optimistic scenario as previously outlined, funded ratios would likely continue to rise. Plans may hit triggers on their glide paths, which would likely call for shifting assets away from equities or other return seeking assets in favor of liability hedging fixed income. Importantly, some sponsors may make these shifts even if they expect interest rates to rise further as the strategy for the pension shifts more towards matching liabilities as funded levels improve. Higher funded ratios may also spark more risk transfer activity, such as annuitization and lump sums, as higher funded levels may enable a sponsor to undertake some of these actions without having to make an incremental contribution.
Even under the pessimistic scenario we expect plan sponsors to continue to consider risk transfer opportunities. PBGC flat rate premiums are scheduled to rise almost 8% in 2017, which brings the total percentage increase in this expense to almost 100% since 2012. We expect many plans to continue to pursue risk transfer as a means of lowering the overall cost.
In addition, we anticipate increased hedging even under the pessimistic scenario. Some plan sponsors have seen a notable rise in funded levels over the past two months. During previous periods of rising funded levels, such as the 2006 – 2007 and 2013 time periods, some plans did not take actions to lock in that improvement and, consequently, saw those gains evaporate. We believe plans may act differently this time around if the improvement in funded status appears to be at risk.
Finally, if a pessimistic scenario does cause funded levels to drop, we believe more sponsors will re-visit contribution strategies, even if none is required, as a means of minimizing PBGC variable-rate premiums. This might include borrowing in the capital markets to fund contributions, a strategy which we saw several plans undertake in 2016.
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