Corporate pension plan sponsors are required to estimate their defined benefit pension plans’ funded status on a regular basis to determine if they have adequate assets to meet the benefit obligations promised to participants. Actuaries attempt to determine the value of future benefit payments (the liability) in today’s dollars, which they then compare to current assets. During this time-value-of-money exercise, actuaries essentially discount future payments by an assumed interest rate often referred to as the discount rate. When this discount rate is higher, the present value of liabilities is lower and vice versa.
The discount rate used will differ depending on the purpose of the actuarial valuation, but the two most common uses are for determining how much cash the plan sponsor is required to contribute (funding considerations) and how to recognize these costs in financial statements (accounting considerations). This legislation focuses on funding considerations and has the largest impact on funding levels reported to participants and minimum contributions required by the plan sponsor.
The Highway Transportation Funding Act of 2014 extends provisions previously included in MAP-21 that prescribe artificially high interest rates and, thus, lead to higher funding measures. These provisions were included initially in MAP-21 and subsequently in the Highway Transportation Funding Act of 2014 to offset the cost of funding the Highway Trust Fund. In short, if pension plan sponsors contribute less to pension plans they will receive a smaller tax deduction, resulting in increased tax revenues to pay into the Highway Trust Fund.
A Few Details
When Congress passed MAP-21 in 2012, the law allowed actuaries to shift from using a 2-year average of interest rates based on maturity to allowing the use of a corridor around 25-year averages. Essentially, actuaries reference the 2-year average of interest rates at a given maturity. If that number is below the corridor as defined in the Table One, actuaries use the minimum rate relative to the 25-year average. This table demonstrates the change in the minimum corridor as prescribed under MAP-21 and the Highway Transportation Funding Act of 2014. As an example, if the 2-year average is below the 25-year average in 2016, actuaries will be able to use a discount rate equivalent to 90 percent of the 25-year average, a rate 20 percent higher than what was originally defined in MAP-21.
Passage of this new legislation leads to an immediate increase in discount rates in 2014. They will remain at elevated levels until funding relief runs out in 2021. The impact to the overall effective discount rate will vary by plan based on participant demographics, but the trend should hold true for most plans.
To get a sense of the magnitude of this impact, we looked at a sample plan and calculated the effective discount rate and funding levels through 2021 under the new and old legislation. We assumed that interest rate averages and assets would remain constant during this time period and that there were no additional benefit accruals. The plan examined had an initial funding status of 92.5 percent under previous legislation.
While this exercise is overly simplistic, Table Two demonstrates the potential impact to discount rates and funding levels through 2021. The largest discrepancy between the new and old rules occurs in 2016 and 2017 when Congress would have phased out funding relief under MAP-21. After 2017, discount rates gradually migrate towards original levels as funding relief wears away.
One noteworthy fact is that none of these rates represents the economic liability as measured by current (spot) rates or the rates that an insurer would use to determine the value in a pension risk transfer transaction. In short, these artificially high rates underestimate the economic reality of funding levels. Remember that artificially higher funding levels mean lower required contributions.
Contribution Strategy. We continue to believe that most plan sponsors should rely on a mix of asset performance, interest rate risk, and contributions as part of a long-term strategy to achieving a fully funded status. Plan sponsors with a shorter time horizon should focus on contributions, which is the only variable not subject to market forces. The degree to which plan sponsors rely on each of these levers will differ based on capital market views, corporate finance views, and the economic reality of their businesses. While some plan sponsors should take advantage of funding relief due to business circumstances, we continue to emphasize that contributions are an important lever to improve funding levels. Plan sponsors who choose to forgo current contribution strategies should stress test the impact to funding as this relief dissipates with an eye toward various capital market and business environments.
Hedging Strategies. CAPTRUST recommends that liability-driven investing strategies and hedging strategies (those designed to mitigate the impact of interest rate movement on funding status) focus on an economic measure of liabilities reflective of current spot interest rates and not artificial measures of funding.
As always, we are committed to monitoring these changes and the implications to our clients and stand ready to assist you as you evaluate the implications to your organization.