Director | CAPTRUST Defined Benefit Practice Leader
In July, President Obama signed the Moving Ahead for Progress for the 21st Century Act (MAP-21) — formerly known as the Highway Bill — into law. While the law’s primary function is to provide for highway and transportation funding, it also contains provisions that impact qualified defined benefit plans. More specifically, one of the new law’s provisions affects the discount rates used to determine minimum required contributions to pension plans.
By way of background, pension plans use discount rates to determine the present value of future payments to retirees. Since the enactment of the Pension Protection Act of 2006, these discount rates have been based upon the yields of high-quality (AA-rated) corporate bonds. Since 2008, falling yields on these bonds have forced plan sponsors to contribute painfully high cash amounts to maintain funding levels. Lower yields (and, therefore, discount rates) mean a higher present value of liabilities and, thus, require a larger cash outlay to maintain or improve a plan’s funding status. This is analogous to the predicament faced by an individual investor who expects to receive a lower rate of return on his retirement assets: all things being equal, he will need to save more today to accomplish his financial objectives.
With MAP-21’s passage, actuaries are now able to use discount rates based on a corridor around the 25-year average yield of high-quality corporate bond interest rates to determine minimum required contributions — rather than the 2-year
average that was primarily used under previous regulations. Minimum discount rates for those plan sponsors electing to apply MAP-21 rates will be effectively 90% of the 25-year average in 2012 as shown in Figure 1. The law then gradually reduces the corridor to 70% by 2016. Figure 1 also demonstrates the difference between the published 2-year and 25-year average segment rates as of July 2012.
By allowing plan sponsors to calculate their contributions using the higher (as of this writing) 25-year average rate, MAP-21 provides a form of temporary funding relief. The new law will likely result in higher tax revenue for the government, since plan sponsors that contribute less to qualified retirement plans will also not be taking the associated deduction. These revenues will help to offset the expense associated with other provisions of the bill.
Determining contributions based on the new rates, relative to previous calculations, can lead to materially lower contributions. As an example, a $100 million plan with a 15-year duration (a measure of price sensitivity due to interest rate changes) would experience a $15 million decrease in the present value of liabilities for every 1% increase in the discount rate. Given that plan sponsors generally contribute normal costs plus one-seventh of the amount they are underfunded in a given year — absent asset smoothing, other funding relief measures, and actuarial chicanery — using the 25-year average rate could have a dramatic impact on annual funding requirements.
In Figure 2, we have taken an anonymous sample of representative client pension plans to estimate the impact of funding levels based on these new rates (using a bit more detailed calculation than described above) relative to other measures of funding. The intent of this analysis is to estimate the impact of higher discount rates used to determine pension liabilities on funding ratios, and it does not account for many other tools that actuaries can use in official calculations. Plan sponsors should engage in a more formal conversation with their actuary, and the results will almost certainly vary from these estimates.
In the above exhibit, the full yield curve estimate in column A reflects liabilities discounted at today’s current rate—which provides an economic view of funding. The annuitization rates in column D estimate the additional cost of purchasing an annuity to settle the liability. The two segment rate scenarios (in columns B and C) demonstrate the impact to funding ratios when smoothing of interest rates is applied.
As you can see from this analysis, the change in interest rates has a materially higher impact on funding levels — especially when plan liabilities have longer duration. Focusing on the difference between the new MAP-21 rates and the true economic cost of settling the liability demonstrates how dramatically understated liabilities are under the new rule set.
At first glance, this legislation looks like a good deal for plan sponsors, so why the title? The answer lies in the fact that it would take a material increase in spot (current) interest rate levels by 2015-2016 to make up for the gradual widening of
the corridor around the MAP-21 25-year average rate. This widening effectively “wears away” the new law’s funding relief. More plainly said, if rates don’t increase by several percentage points across the yield curve in the near term and plan sponsors elect to forgo contribution strategies, funding measures will likely return to lower levels, requiring higher future contributions.
How likely is that? Certainly, there are many paths that interest rates may follow. However, the forward curve (shown in Figure 3) — which reflects market participants’ expectations for interest rates in the future, along with recent Fed guidance that it intends to keep rates low through 2015, suggests that markets do not anticipate a rate scenario that will materially impact the 25-year average by 2015.
So if the relief is temporary and market expectations do not imply a materially rising rate environment before 2015-2016, what should plan sponsors do?
• Consider continuing your current contribution strategy given today’s business climate relative to the potential for higher contributions in future years in an unknown business environment.
• Consult with your actuary on contribution strategies and interest rate expectations—and perform a stress test to ensure that your organization can withstand possible future contribution scenarios.
• Evaluate the other implications of this new law (this article only addresses funding, but there are many other implications of this legislation).
• Continue to use spot measures for estimating liabilities when determining and measuring success of liability-driven investment strategies.
We encourage our plan sponsor clients to evaluate their specific objectives related to their ability to improve funding levels through contributions. While the path you choose may be different based on the factors discussed above, we continue to think that the road to improved funding levels includes some combination of contributions, interest rate changes, and market performance. Only one of those is directly controllable by the plan sponsor. So the question remains: “Pay Now or Pay Later?” Should you have any questions on how this rule set may impact your decision making, please do not hesitate to ask us.