US Retirement Outlook 2019

Transcription

1 US Retirement Outlook 2019 As we turn the page on an eventful 2018, we now look ahead to some key trends and issues that retirement plan sponsors and participants may face in 2019 and provide thoughts on how they might address some of these issues. Jonathan Barry, FSA, CFA Senior Retirement Strategist Uncertainty in the capital markets and lower-for-longer returns As the longest bull market on record limps into its 10th year, market observers are questioning how long the cycle can last, and many investors are positioning for the inevitable end of the cycle. In our view, while overall economic fundamentals such as GDP growth and unemployment are solid, there are several issues that are giving investors pause, including ongoing trade tension with China, uncertainty around the outcome of Brexit and increasing public and individual debt burdens. In our newly released MFS Long Term Capital Market Expectations, we forecast expected returns for the next 10 years for various asset classes. While this update anticipates slightly higher returns for most asset classes as compared with our July release, these returns are still relatively low by historical standards. For example, a hypothetical portfolio of 60% global equity and 40% global bonds is estimated to have a 10-year annualized return of approximately 4.3%. 1 While it is impossible to accurately predict when the cycle will end, defined benefit plan sponsors may want to assess how well their portfolios will weather a potential downturn. A thorough review of the plan s strategic asset allocation may be in order, along with robust scenario testing to quantify and understand the risks inherent in the portfolio and determine any steps that may be taken to try to mitigate those risks if they are higher than desired. We feel defined contribution sponsors should reinforce messaging around saving levels, as the potential for lower future returns may necessitate higher saving levels for many plan participants. Sponsors may want to revisit the educational materials, tools and other resources available to participants to better understand asset allocation and diversification, particularly for those participants who are nearing retirement. Potential increases in interest rates We saw significant activity in 2018 by the US Federal Reserve, with four interest rate increases. As of the writing of this article, the Fed has indicated a continued positive outlook for the US economy, given a strong labor market and positive consumer sentiment. However, global trade tensions combined with signs of potentially peaking growth have resulted in more dovish comments from the Fed, with Chairman Powell recently saying we may be just below the neutral federal funds rate, which could result in potentially fewer rate hikes than expected in page 1 of 7

2 While we anticipate a modest increase in short-term rates, we see mounting headwinds that could hamper sustainably higher rates at the longer end of the curve and expect that longer-dated Treasury yields will persist near their current levels. We also anticipate credit market volatility will persist due to economic uncertainties and continued monetary policy normalization. For defined benefit plans, this combination of factors could result in a modest decrease in plan liabilities, assuming stable long-term treasury yields and potentially wider credit spreads. This decrease could be offset by corresponding fixed income performance for sponsors who have hedged some or all of their interest rate exposure. The new year is a good time for sponsors to revisit their fixed income portfolio and make sure it is still appropriately aligned with plan liabilities, which may have changed during the year due to demographic movements. For defined contribution plans, we generally do not suggest significant changes in allocation due to shortterm interest rate movements, but participants should review their portfolio to determine if their asset allocation and risk profile is right for them given their circumstances. Plan sponsors and participants may also want to review the fixed income strategies available and consider whether broadening their fixed income allocation through the addition of global, high yield or emerging market bonds could help to diversify their overall portfolio. Increased volatility As shown in Exhibit 1, investors have experienced relatively low risk over the past several years compared to historical standards; however, in 2018 volatility spiked in February and again for the better part of the fourth quarter, which caught many investors off guard. As noted above, we feel there are several issues that will continue to drive market uncertainty, which we believe will result in higher levels of volatility during Exhibit 1: Historical VIX Index VIX Index level Average Source: Factset. Figures shown from 31 December 2003 to 31 December Average (green line) based on period from 31 December 1998 to 31 December Chicago Board Options Exchange (CBOE) Market Volatility Index = VIX page 2 of 7

3 We are also keeping a close eye on correlations between stocks and bonds (as well as other asset types), which are sometimes overlooked as a key driver in portfolio construction. As shown in Exhibit 2, for roughly the past 20 years, we have seen a period where equity and fixed income correlations have been largely negative, which stands in stark contrast to the mostly positive correlation seen during the prior 20 years ( ). This period of negative correlations has been of great benefit to asset owners, providing for excellent diversification for balanced portfolios of stocks and bonds. Exhibit 2: Three-Year Stock/Bond Correlations Correlation Average Source: Factset, as of 31 December Three-year correlation between the S&P 500 Index and the Bloomberg Barclay's US Treasury Index. Past performance is no guarantee of future results While changes in volatility and correlations do not necessarily change the median expected return for a portfolio, they can significantly impact the potential range of outcomes as shown in Exhibit 3. 2 Exhibit 3: Potential change in range of outcomes over one year 30% 20% 10% Return 0% -10% -20% Baseline assumptions Increase volatility and correlation Source: Range of outcomes under baseline assumptions scenario represent the 5th to 95th percentile of potential outcomes based on a normal distribution of outcomes based on an allocation of 30% US equity, 24% EAFE equity, 6% Emerging Market equity and 40% US aggregate fixed income using expected return and volatility assumptions detailed in MFS Long Term Capital Market Expectations,. Increase volatility and correlation scenario assumes volatility for all asset types increases by 50% (e.g. a volatility of 10% increases to 15%), and the correlation between all equity classes increases to 1.0 and the correlation between fixed income and equity increases to 0.3. page 3 of 7

4 We suggest investors analyze their portfolios to understand the sensitivity to potential changes in volatility and correlations and take steps to try to mitigate if the range of outcomes is too wide given their objectives. That being said, both defined benefit plan sponsors as well as defined contribution plan participants should consider not overreacting to short term spikes in volatility. For investors with a long- time horizon, nearterm increases in volatility may seem frightening but in our view may be manageable over the long term. Modest improvements in pension funded status and continued expansion of LDI strategies Tepid returns in equity markets, combined with rising interest rates, saw negative returns for many investors in Despite this, many pension plan sponsors did see improvement in funded status, with the estimated aggregate funded status for US corporate defined benefit plans improving from 84% to 91% funded year to date through November 3 although the market downturn in December could result in a significant reduction in overall funded status. The improvement through November was largely driven by an increase in interest rates, which decreased the value of plan liabilities, as well as an increase in discretionary funding, spurred by changes in the tax law that incentivized many plan sponsors to make additional contributions to their plans. A combination of relatively low equity returns and a modest increase in rates in 2019 could result in a neutral-to-slight improvement in funded status for a typical plan. Even though many sponsors still benefit from funding relief that allows for relatively low minimum contribution requirements, this relief will likely wear away over the next few years, and sponsors may want to consider more aggressive funding in the near term to help close any remaining deficits. The increase in funded status seen through much of the year helped drive continued implementation and refinement of liability- driven investing (LDI) strategies, and sponsors who were employing such strategies should have weathered the year end volatility without too much trouble. For sponsors with an existing LDI framework, we feel the new year is a good time to review their portfolio and adjust as appropriate to ensure they continue towards their desired endgame. Sponsors who have not taken an LDI approach, but who are concerned with potential uncertainty in equity markets and interest rates, may want to take another look at their level of funded status risk to make sure it is manageable. If it is not, they may consider strategies that could help to mitigate that risk. Continued expansion of the pension risk transfer marketplace 2018 saw significant activity in the risk transfer space for defined benefit plans, with single premium annuity buyouts reaching nearly $16 billion through the third quarter and potentially exceeding $23 billion for the year promises more of the same and perhaps even increased activity given the potential increase in pension plan funded status noted above coupled with continued increases in PBGC premiums. 5 The trend of cashing out deferred vested participants has slowed over the past few years, as many sponsors have already made multiple cash out offers to participants; however, we may see a slight uptick in activity in 2019, as higher interest rates used to calculate lump sum values could make a cash-out program more affordable for the plan sponsor. page 4 of 7

5 Plan sponsors considering cash-out, partial annuity buyout or full plan termination programs will need to ensure that their asset allocation is aligned with their risk transfer strategy. Careful consideration should be given to which assets will be liquidated to make payments and what the asset allocation will look like post-transfer. Sponsors considering asset-in-kind transfers to an insurer for an annuity buyout should work with their portfolio managers and prospective insurers to review fixed income holdings and determine any adjustments to be made to the portfolio prior to the transfer. To the extent that participants are given an opportunity to take a lump sum from the defined benefit plan, sponsors should ensure that participants have clear and concise guidance on the pros and cons of taking a lump sum and should also review their 401(k) plan s fund lineup to determine if any changes are warranted given the potential inflow of assets. Increased focus on longevity and retirement income solutions After many decades of significant mortality improvement in the United States, we actually saw a modest decrease in life expectancy in 2017, with average life expectancy currently at 78.6 years. 6 It is not clear whether this slowing is a temporary trend or the beginning of a longer-term pattern. Defined benefit plan sponsors have long been focused on longevity, with mortality table and improvement scale updates that have resulted in significant increases in plan liabilities. However, these improvement scales have been pared back over the past few years as actual mortality improvement has not kept pace with the original estimates and liabilities have slowly been declining as a result. Defined contribution sponsors and financial advisors are beginning to put more focus on longevity for their participants as they wrestle with the right types of solutions to provide. With roughly 10,000 baby boomers retiring each day, 7 many of whom will rely solely on defined contribution assets for their retirement needs, there is immense demand for products and services that can help participants receive a predictable source of income from their savings. A recent proposal in Congress would remove some of the ambiguity around fiduciary standards related to lifetime income solutions and could help to eliminate one of the roadblocks that currently prevents many plan sponsors from offering such options. 8 However, there is still significant work to do to ensure a comprehensive framework is in place. We anticipate 2019 will see significant movement in the area of longevity solutions for defined contribution participants. There is no one-size-fits-all solution but rather a framework that might include Social Security, income generating investments, annuity products and spending strategies. We also see fintech playing a major role here, which could allow for customized solutions for individual retirees. Plan sponsors will need to keep a close eye on developments in this space, as things could evolve quickly. page 5 of 7

6 Limited movement on retirement plan reform from the new Congress The 115th Congress convenes in January, with the Democrats taking control of the House and Republicans maintaining a hold on the Senate. While we do not expect to see any major policy changes on the retirement front, there are a few areas where we expect to see some activity, including the following: Progress toward the establishment of multiple employer defined contribution plans (MEP) This would allow for unrelated companies to participate in the same plan. In October, the US Department of Labor (DOL) proposed a rule that would expand MEPs to cover a wider range of employees, but it did not allow for a fully open MEP. There appears to be bipartisan interest in this concept, which could help small employers more easily provide retirement benefits to their employees. Support for multiemployer defined benefit plans in critical health There are proposals in the works to help shore up the Pension Benefit Guarantee Program (PBGC) insurance program for multiemployer plans, which potentially could be insolvent by the end of fiscal year 2025 if it is called on to take over a number of anticipated multiemployer insolvencies over the next several years. The multiemployer crisis has been looming for many years and finally appears to be coming to a head. More flexibility for plan sponsors around small balances In November, the DOL issued an advisory opinion on an auto portability program that would allow for employers to automatically transfer small retirement accounts to the plan of a new employer once the employee finds a job. The advisory opinion is limited in scope and does not address a number of fiduciary issues that could arise in this type of a program, but we would expect to see some of these issues clarified in This is a small step that will help with the issue of disrupted journeys that has become more and more prevalent over the past several years. With more workers working multiple jobs throughout their career, there are many that have small account balances scattered among several employers, and the ability to more easily aggregate account balances will help participants better plan for their retirement. With so many varied issues to consider, the one thing we can rely on is that there are sure to be surprises, so we hope this piece helps plan sponsors prepare for what will certainly be an eventful page 6 of 7

7 Endnotes 1 Source: MFS Long Term Capital Market Expectations (US Edition). 2 Source: MFS Long Term Capital Market Expectations (US Edition). Market Expectations. Range of outcomes based on an allocation of 30% US equity, 24% EAFE equity, 6% emerging market equity and 40% US aggregate fixed income. Assumes volatility for all asset types increases by 50% (e.g., a volatility of 10% increases to 15%), the correlation between all equity classes increases to 1.0, and the correlation between fixed income and equity increases to Source: Mercer press release on S&P 1500 Pension Funded Status, December 6, Source: LIMRA Secure Retirement Institute press releases, May and December, Source: Pension Benefit Guaranty Corporation: For 2019, the flat rate premium will increase to $80 per participant in 2019, and the variable rate premium will be $43 per $1000 of underfunding. 6 Source: Center for Disease Control National Center for Health Statistics Fastats, November Source: AARP. 8 The Retirement Enhancement and Savings Act of 2018 would allow for defined contribution plans to make a direct transfer of lifetime income investments to another qualified plan. 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