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January 2018 | Pension Solutions

US Corporate Pension Review and Preview: Inflection Points

As we have turned the page on 2017 and look forward into the rest of 2018, the US corporate defined benefit (DB) system seems to be at an inflection point on multiple levels.

  • First, funded status may be at an inflection point. When all of the annual reporting for plan sponsors is completed over the next few weeks, aggregate funded status for the system will likely show its first year-over-year increase in four years. Continued rises in interest rates, equity values, and contributions could further augment funded ratios in 2018.
  • Second, the approach sponsors are taking to manage pension plans appears to be at an inflection point, as well. Many sponsors have recognized the economic benefits of voluntarily contributing to their plans, as well as increasing hedge ratios, even in an environment where interest rates are expected to rise, given the changes to Pension Benefit Guaranty Corporation (PBGC) premiums and corporate tax rates.
  • Finally, all of this means that asset allocation may be at an inflection point too, as more and more sponsors execute on long-held plans to increase fixed income allocations in an effort to better match plan assets with plan liabilities.

Below, we provide some thoughts and observations around how corporate DB plans ended 2017 and some strategies these plans may employ in 2018.

Inflection Point 1 – System-wide funded status poised for first annual increase since 2013

Robust contribution activity combined with double-digit asset returns for many plans will likely result in the first annual rise in funded status for the US corporate DB system since 2013.1 Our model suggests the aggregate funded status of the US corporate DB universe was 85% as of the end of 2017, up from 81% at the beginning of that year. Key factors that influenced changes in funded status in 2017 include:

  • Voluntary contribution activity gained momentum: A desire to reduce PBGC variable-rate premiums as well as reap a larger tax deduction given changes to corporate tax rates helped to fuel significant contribution activity in 2017. Much of this activity occurred despite the fact that many plans had little to no mandatory contribution requirement in 2017. We project that aggregate contributions to US corporate plans were up over 20% in 2017 in comparison to the prior year.2 Some of the most significant reported contributions in 2017 were funded via a debt capital raise, a topic we addressed multiple times over the past year and a half.3
  • Actual asset returns exceed expected returns…again: Based on the aggregate asset allocation of US plans as of the end of 2016, as well as observed market returns for commonly used benchmarks in 2017, we estimate that actual asset returns for the corporate DB system were around 12%-15% last year. Equity markets, both in the US and internationally, returned in excess of 20%, and many areas of the fixed income market delivered returns in the high single digits. Individual plan results will vary based on the specific asset allocation employed. These results differed from the average long-term return assumption used by US corporate DB plans last year of 6.9%. If our predictions for 2017 actual results are correct, this will mark the seventh time in the past nine years that actual asset returns have exceeded long-term expected returns across the system.
  • Discount rates continue to touch new lows: The rise in funded levels that many plans may report for 2017 occurred despite the fact that accounting discount rates have declined once again and have hit the lowest levels since we began tracking this data, over fifteen years ago. While the yield on the 10-year US Treasury was virtually unchanged in 2017, credit spread tightening contributed to a decline in many indices that are considered proxies for pension accounting discount rates. For example, the Moody’s Aa, a popular benchmark used to help set pension discount rates, declined almost 50 basis points during 2017, much of which was due to the aforementioned tightening of credit spreads.4 Companies with a December-end measurement date for their plans may likely use discount rates below 4%, down from an average discount rate of about 4.1% at the end of 2016. As a result, based on this and other factors, we estimate that aggregate gross pension obligations increased approximately 5% year-over-year.
     

Inflection Point 2 – Sponsor approach to pension management continues to evolve

As noted earlier, one of the main catalysts for the likely increase in funded levels in 2017 was notable voluntary contribution activity. Companies such as Boeing, Verizon, Delta, and FedEx all made multi-billion discretionary contributions in their most recently completed fiscal years. In the past, many sponsors employed a fairly straightforward contribution strategy. That is, they contributed the minimum required under ERISA given other potential uses of cash for actions such as buybacks, dividend increases, capital expenditures, and mergers and acquisitions. Now, given higher PBGC premiums on deficits and a limited window of opportunity to contribute and potentially reap a tax deduction at the old, higher corporate tax rate, more sponsors are accelerating voluntary contributions.

Inflection Point 3 – Asset allocation likely to see increases to fixed income

When plans report their year-end asset allocations along with their other pension-related metrics over the next few weeks, some plans may once again report an increase in their overall fixed income allocations. These allocations have been slowly rising over the past few years despite persistently low interest rates and funded levels. With many plans having some sort of glide path or journey plan in place that calls for increased allocations to fixed income as funded status improves, increases in funded levels, whether due to asset returns or contributions, would be expected to be a catalyst for increased rotation into long-duration fixed income. Some of these increases to fixed income allocations may be sourced from equities or other asset classes with more return seeking characteristics. As we expect notable contribution activity to continue in 2018, additional increases to fixed income allocations may occur again this year.

Looking Ahead – Several factors will likely continue to incentivize a “fund, de-risk asset allocation, and risk transfer” trifecta in 2018

Our outlook for 2018 is more of what we observed in 2017, except in many ways accelerated. We expect many plan sponsors may continue to voluntarily contribute to their plans, shift asset allocation to one that better aligns assets with liabilities and reduces exposure to equity beta, and shrink their plans through risk transfer actions. Several catalysts may drive these actions:

  • Potential ability to capture tax deduction at higher rate into 2018: Plan sponsors can, under certain circumstances, make a contribution up to eight and a half months after the end of the year and still count it as a deduction for the previous tax year. Just as a number of sponsors made voluntary contributions in 2017 to claim that higher tax deduction, some may do the same in 2018. Our conversations with plan sponsors suggest that some may be considering a voluntary contribution in 2018, even if they already made one in 2017, or increases to previously planned contributions.
  • PBGC premiums continue to move higher: The ever-increasing premiums have been a number one topic of client conversations over the past few years. Flat rate premiums will increase more than 7% in 2018 and have now more than doubled since 2012. Variable-rate premiums, generally paid on a plan’s deficit, have risen to 3.8% in 2018 from 3.4% in 2017. For many plan sponsors, the decision whether or not to carry a deficit or keep participants in the plan includes a calculation around the costs involved of the status quo.5 As those costs move higher given these annual increases, some plan sponsors may likely continue to take proactive steps to reduce deficits through voluntary contributions and decrease the number of participants in the plan through risk transfer.
  • Mortality change is effectively another PBGC premium increase: In October 2017, the IRS and US Treasury finalized mortality changes for ERISA funding/PBGC purposes similar to the changes that had been enacted for US GAAP reporting back in 2014. For some plans this may result in a higher valuation of their pension obligations and, therefore, a larger deficit, holding all else constant.6 Since the PBGC’s variable-rate premium is generally calculated based on the size of the deficit, this upward revision to the valuation of the liability may result in higher PBGC variable-rate premiums. This provides another potential incentive for sponsors to increase funded levels through contribution activity and then reduce funded status volatility through asset allocation shifts.
  • Funding relief will roll off over the next several years: Various versions of funding relief that had been enacted and updated by US Congress over the past several years will, absent further relief, begin to roll off over the next few years given the mechanics of the calculations around setting discount rates. Similar to the mortality issue noted above, for some plans, ERISA liabilities and funding requirements may rise in the next few years. Making a voluntary contribution can help to mitigate some of those higher deficits in future years as well as help to reduce any associated PBGC variable-rate premiums.
  • Continued focus on reducing impact of the plan on the sponsor: Over the past several years, many companies have explored strategies to reduce the impact of the DB plan on the sponsor’s balance sheet, income statement, and cash flow. In some cases, this has taken the form of a plan freeze, a strategy that continues to be used as evidenced by actions announced by companies such as UPS, General Mills, Alcoa, and Arconic over the past year. The trifecta of funding, de-risking asset allocation, and transferring liabilities to a third party may be additional tools in the pension risk management toolbox for sponsors seeking to achieve a goal of reducing financial impact from their DB plans.

ABOUT THE AUTHOR

Michael A. Moran, CFA

Michael A. Moran, CFA

Managing Director, Chief Pension Strategist, Goldman Sachs Asset Management

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