by Michael Clark and Justyna Mietelska
2016 was an interesting year for many reasons. Long corporate interest rates continually declined until just after mid-year and then shot up after Election Day. At their lowest point, rates were almost 1% below where they started the year, but ended with rates down about 0.20% compared to the beginning of 2016. Equity markets started the year off in negative territory but most markets rebounded strongly. The combination of these asset and liability drivers created funding level volatility and angst but despite that most plan sponsors finished the year with an improved funded status.
Unlike the last few years, no major pension legislation was passed during 2016. We did see proposed regulations for incorporating new mortality tables into minimum funding, PBGC, and lump sum calculations. One significant theme in 2016 was risk transfers. This article reviews how the economic changes along with legislative and industry updates will shape the corporate pension plan landscape going into 2017.
Legislative – B (status quo)
Congress passed no new legislation during 2016. The IRS issued proposed regulations regarding how new mortality tables will be incorporated into minimum funding liability calculations. These new mortality tables stem from the2014 Society of Actuaries (SOA) mortality tables (and subsequent updates in 2015 and 2016) that showed increased life expectancies. Once finalized, the new IRS mortality regulations will affect minimum funding target liabilities, PBGC liabilities, and lump sum calculations. (See our article IRS Mortality Tables … Finally!).
This year, plan sponsors will want to make sure they understand the implications on their projected required contributions as it is anticipated that the new tables will take effect in 2018. For PBGC purposes, it is anticipated the expected increase in the PBGC funding target liability will push more plans to the point where their variable rate premiums will be capped.
Pension Risk Transfers – A (plan sponsors take note!)
The annuity purchase market was red hot in 2016. For many plan sponsors, especially those subject to the PBGC variable rate premium cap, purchasing annuities from an insurance company for small annual benefit retirees became a ‘no brainer.’ Initial reports from insurers indicate that 2016 was on track to reach upwards of $13B in annuity purchases.
Plan sponsors will want to evaluate whether or not an annuity buyout makes sense for them. (For more information on what this entails, see our free webinar Pension Plan Annuity Purchases: The Time is Now!). Plan sponsors tend to find that the high administrative costs (PBGC premiums, recordkeeping, etc.) justify purchasing annuities now.
Mortality Assumptions – B+ (lower liabilities again)
Similar to 2015, the SOA published an updated mortality improvement projection scale in the fall of 2016. The new projection scale was the result of incorporating two additional years of Social Security data into the SOA’s mortality model. Recent experience has shown less improvement in mortality rates than expected.
Plan sponsors can expect another reduction in accounting liabilities due to the 2016 update. For those sponsors using the RP-2014 mortality tables with the MP-2015 improvement scale, updating to the new projection scale should see a reduction in accounting liabilities of anywhere from 1.5% – 2.0% (See our article 2016 Mortality Table Update – Lower Liabilities Again!).
Interest Rates (Accounting) – B (volatility still wreaking havoc)
The high-quality corporate bond yields that are used for financial accounting were on a continual decline through the first half of the year. The second half of the year had modest increases culminating in a significant increase after the election. The discount rates sponsors will select at year-end will most likely be about 0.25% lower than last year-end.
Similar to 2015, discount rates were volatile in 2016 with an almost 1% difference between high and low points through the year. The Citigroup Pension Liability Index for average plans as of December 31, 2016 is 4.14%, which is a 19 basis point decrease over the December 31, 2015 rate of 4.34%.
Interest Rates (Funding) – C (still artificially high)
The underlying yield curve used for determining the liabilities for minimum funding has been generally flat since the beginning of the year, with slight decreases in yields at the middle and long end of the curve.
The 10% corridor around the 25-year historical average interest rates continues to be in effect for 2017. The 2017 rates will be slightly lower than the 2016 rates with decreases of approximately 0.25% in the first segment, 0.20% in the second segment, and 0.15% in the third segment. Similar to changes from 2015 to 2016, liabilities for contribution purposes in 2017 will be higher by about 2% – 4%.
Market Performance – B
The year started with a volatile first quarter impacted by fears towards weakening global growth as well as low oil prices. The ECB and Japanese Central Bank responded with additional stimulus while the Fed refrained from further rates hikes. Midway through the year the markets traded off due to Brexit (see our view on the impact of Brexit), but the selloff was short lived. November brought about the U.S. Presidential election and a reflationary environment with the dollar, equities and interest rates increasing (see our view on the impact of the US Election). The Fed raised rates in December and minutes show plans for three rate increases in 2017.
The year ended with the S&P 500 up 12%. Developed international equities though produced lackluster returns with the MSCI EAFE Index up only 1%, largely affected by the appreciating dollar which increased 7% versus a broad basket of currencies. Emerging market equities had a strong year with an 11% return.
Plan sponsors with the traditional 60% equity/40% aggregate fixed income portfolios have in general seen their portfolios return approximately 6%, while those with more off-risk assets have seen that portion of their portfolio increase in similar magnitude to their liabilities.
Thoughts Going Into 2017
Here are some things to watch for and consider as we move through 2017:
- “Shrink the ball! – Lump Sums” – 2017 is a critical year for plan sponsors to reduce their pension liability. The IRS will be updating the mortality table used for minimum funding and lump sum calculations in 2018 that will, in general, increase costs. Plan sponsors will want to monitor interest rates to determine whether offering vested terminated participants the option to receive a lump sum distribution will be economically advantageous in 2017. If rates are lower than at the beginning of the year, it will probably make sense. If rates substantially increase it may make sense to wait until 2018 despite the mortality table change.
- “Shrink the ball! – Retiree Carveouts” – The trend of annuity purchases is expected to continue in 2017. The insurance industry is projecting total purchases similar to 2016 but is expecting an increase in the total number of transactions. That means that more sponsors will be looking to offload their small (and even mid-sized) annual benefits to an insurance company. We continue to believe that annuity purchases for small annual benefit retirees is a ‘no brainer’ with the increasing administrative costs for maintaining those participants within the pension plan.
- The economy – The markets are increasingly swayed by politics and fiscal policy versus central bank policy (monetary) in the U.S. In Europe monetary policy and upcoming elections could bring about increasing volatility. The big story of 2017 looks to be what happens with the U.S. Dollar. The dollar has already strengthened significantly in the past two years and rallied strongly following the U.S. election. A stronger dollar can act in a similar way to interest rate rises in helping to control inflation, but it also exacerbates the trade deficit. It’s something that plan sponsors should monitor. Plan sponsors will want to evaluate liability driven investing strategies and/or equity hedging strategies to minimize their pension plan funded status volatility during the year.
- Cash considerations – Plan sponsors will need to continue to evaluate the long-term cash funding impacts of the legislative changes enacted over the last few years. Contribution requirements will remain suppressed again in 2017. But if, and when, the current interest rate corridor expands, sponsors will see large increases in cash calls. Larger contributions now will prevent shocks later and save PBGC premiums.
- Legislation – It’s hard to say how the legislative front will shape up in the Trump administration. Thoughts from various employee benefit plan groups indicate increases in PBGC premiums and a continued 10% corridor on minimum funding interest rates are not out of the question.
Michael Clark is a director in P-Solve’s Denver office and Justyna Mietelska is an investment consultant in P-Solve’s Boston office.