Pension Investment Implications of Recent Funding Relief Legislation

Transcription

1 Pension Investment Implications of Recent Funding Relief Legislation Moving Ahead for Progress in the 21 st Century Act July 2012 Hewitt EnnisKnupp, An Aon Company 2012 Aon Corporation

2 Executive Summary On Friday, July 6th, President Obama signed into law the Moving Ahead for Progress in the 21st Century Act (MAP-21). The legislation includes several provisions affecting pension plans subject to the Pension Protection Act. The main changes to pension rules are on the assumptions for calculating the Target Liability and PBGC premiums, which reduces the required contributions for many plan sponsors, changes their exposure to interest rate risk, and increases the operational costs of running a plan. MAP-21 temporarily decreases the PPA pension liability by defining a minimum interest rate to be used for pension liability valuations, which is higher than the interest rate pension plans are using today. 1 This has implications to both funding and investment strategies of pension plans. From a near-term PPA regulatory perspective, there is an increased risk that in a rising interest rate environment, a pension plan s long duration assets could decline while liabilities increase. As such, pension plan sponsors who are focused on near-term cash requirements may decide to shorten the duration of their assets in order to minimize this potential effect. Note that these changes only affect the near-term minimum required funding to pension programs. These rules do not directly affect pension accounting 2, nor do they affect long-term pension plan economics. Due to the expected short term nature of the relief, we do not expect significant shifts in long-term pension management. There may, however, be short-term strategy adjustments. Pension Plan Risk Management Framework Figure 1 shows the four major levers for plan sponsors to influence their risks, with each interacting with others. For example, by changing the interest rate assumption, the new law reduces contributions and interest rate risk, which may influence the level and types of risk that plan sponsors may want to take in their investments. This white paper focuses on how the legislative changes affect the risk profiles of plan sponsors, and how those may affect the investment strategies plan sponsors prefer. 3 Investment Policy Funding Strategy Plan Design Assumptions and Methods Risk Management Figure 1 1 MAP-21 is a permanent change to the law, but the increases in interest rates are structured to have greater impacts over the next few years than long-term. 2 There is an indirect effect on pension accounting, as lower contribution levels translate to lower asset levels, which affects the Expected Return on Assets component of accounting expense. 3 A more detailed discussion of the details of the new law can be found in our other white paper at: 1

3 Changes to Interest Rates Drive Contribution Reductions In 2012 and beyond, MAP-21 typically increases interest rates for discounting plan liabilities by establishing a corridor for the 24-month average segment rates that are used for pension funding purposes. (In some scenarios with very significant increases in effective interest rates above 8%, MAP-21 could actually decrease the allowable rates.) The corridor is based on a 25-year average of the segment rates, and it widens over the next several years. If market interest rates remain at current levels, the MAP- 21 funding interest rates are expected to decline over time and become very close to the funding interest rates under prior law by 2017 or Figure 2 compares how the Effective Interest Rate for a typical plan would be affected by the new law, assuming rates do not change. As of January 1, 2012, the Effective Interest Rate for a typical plan would increase from 5.54% in the prior law to 6.60% estimated in the new law, which could reduce the Target Liability by 10-15% for most plan sponsors. 9% Estimated Projected Interest Rates Assuming May, 2012 Rates Stay Constant Thereafter 8% 7% 6% 5% 4% 6.60% 5.54% 6.08% 5.02% 5.56% 5.08% 4.62% 4.55% 4.50% 4.49% 4.49% 4.48% 4.54% 4.45% 4.44% 4.44% 4.44% 4.44% 4.44% 4.44% 3% Note: Figure 2 Corridor for New Interest Rates (based on a 25-year average of interest rates) Estimated New Law Interest Rates (must be within the corridor) Prior Law Interest Rates In 2012, the corridor is 90% 110% of the average interest rate for the last 25 years. The corridor expands to 85% 115% of the average in 2013, and it keeps expanding 5% per year thereafter until reaching 70% 130% in New law interest rates are estimated pending IRS guidance. Actual corridor interest rates could be higher, or lower, than the amounts shown above. The green bars in Figure 2 represent the range of the corridor. When the 24-month smoothed rates are within that corridor, the interest rate would be the same as the prior law. It is important to note that the range gets wider and the floor on rates gets lower as we progress to The interest rate corridor has two major impacts on plan risks and horizons: The changes significantly reduce interest rate risk in the next several years. Rates cannot drop below the low end of the corridor (estimated with the green bar in Figure 2), so further decreases in market rates will not increase the liability used to calculate required contributions. 2

4 The changes significantly reduce contributions through 2015, potentially by 30% or more. This may be better described as delaying, rather than reducing contributions, as eventually sponsors will have to contribute enough to fund the benefits promised. Nevertheless, the change lengthens the horizons of plan sponsors to achieve full funding, giving their investments more time to generate returns that may make future contributions unnecessary. In addition, for plan sponsors with dynamic investment policy glide paths based on an unsmoothed liability measure (which is true for most plans with dynamic investment policies), delaying contributions means that their funded ratios for de-risking will not increase as quickly, and thus they will not de-risk as quickly. These changes to plan risks and horizons drive potential changes to investment strategies. Changes to PBGC Premiums Drive Operating Costs of Plans The legislation significantly increases PBGC premiums both flat rate premiums per participant as well as variable rate premiums that depend on the funded status of the plans. The changes in PBGC premiums increase the costs of operating plans, especially on an underfunded basis. The increased operating costs of the plans make it incrementally more appealing to settle liabilities with lump sums or by purchasing annuities, as these would reduce the plan headcount that flat premiums are based on. Further, the increase in variable rate premiums may make it less desirable for plan sponsors to be underfunded, which can be addressed by either increasing contributions or reducing investment risk when well-funded. While we don t expect plan sponsors to make wholesale changes to their risk postures solely driven by the changes to the PBGC premiums, those on the fence could consider this a tie-breaking factor. Investment Implications The investment implications of this new law depend on the level of risk the plan is taking and the most important risk metrics of the sponsor. The grid on the following page summarizes the most likely potential impacts of funding relief on investment strategy. 3

5 Potential Impact of Funding Relief on Investment Strategy Plan s Most Important Metric Accounting, Plan Termination, or Economic Funded Status Contributions Low funded ratio/ High risk budget (e.g. 50% or greater allocation to returnseeking assets such as equities) Typically minimal impact on investment strategy Reconsider how to allocate the risk budget; consider temporarily reducing the duration of the fixed income High funded ratio/ Low risk budget (e.g. less than 50% allocation to returnseeking assets) Minimal impact on investment strategy Typically minimal impact on investment strategy For plans whose most important metric is accounting, plan termination, or the economic funded status, there is minimal impact on the investment strategy because the legislation did not change any of these metrics. For plans focused on contributions, there will be a short-term deferral of interest rate and credit spread risk, which will gradually phase out over the next several years. Plans focused on contributions with a low risk budget will not typically need significant impacts on the investment strategy. There are two reasons for this. First, the new law delays the impact of interest rate risk on contributions, but interest rate risk will eventually reappear when the corridor no longer dictates the rate levels. Plan sponsors with low risk budgets will typically be averse to contribution spikes a few years into the future when this happens, so they would not typically want to adjust their investment strategy. Second, many plans in this category elect the Full Yield Curve rather than smoothed rates to align the asset returns with the liability changes, and the interest rate corridor does not apply to plans that use the Full Yield Curve. These sponsors can elect to move to smoothed rates in order to take advantage of the lower contribution rates. Plans with moderate to high risk budgets that are focused on contributions the category we think might have the largest proportion of plans will have reduced short-term exposure to declines in interest rates, which reduces the overall funded status volatility. So over the next few years, the plans may be able to take on more investment risk to maintain the same level of contribution risk. The additional risk can come 4

6 in the form of more return-seeking assets or by reducing the duration in the liability-hedging assets. For those plan sponsors who choose to take on more risk in the next few years, the decision of which part of the portfolio to deploy that risk may be influenced by their market views. Hewitt EnnisKnupp believes that interest rates will rise over the next few years, so we expect greater advantages to maintaining a low duration fixed income portfolio, as the new law reduces short-term risk from interest rate mismatch. With interest rates at historically low levels, an increasing number of plan sponsors will be implementing hedge paths, which use explicit interest rate triggers to maintain a low fixed income duration (and hedge ratio) when rates are low and extend the fixed income duration as rates rise. This can provide a disciplined, methodical way to manage the pension plan out of the current interest rate environment. Figure 3 illustrates how a glide path and hedge path can be integrated together. First Dimension Glide Path How much to allocate to Return-Seeking and Liability- Hedging Assets Funded Ratio Return Needs Return-Seeking Allocation Second Dimension Hedge Path How to invest Liability-Hedging Assets Interest Rate Level Desired Duration Hedge Ratio Figure 3 Implementing Low Duration Strategies There are three main approaches for plans sponsors desiring to use a hedge path to maintain low duration fixed income strategies while rates are low: Replace long duration bonds with intermediate duration bonds Replace long duration bonds with return-seeking fixed income such as bank loans, complex credit and direct loans Maintain physical long duration bonds, but reduce the duration with derivatives All of these strategies can be used to reduce duration in tandem with glide paths and hedge paths. We ll examine each of these further. 5

7 Replace long duration bonds with intermediate duration bonds. This is the simplest way to implement a low duration strategy. Plan sponsors can use an intermediate duration benchmark instead of long duration. When implementing such a strategy, plan sponsors should be thoughtful about the types of long duration bonds sold as well as the types of intermediate duration bonds purchased. For example, it may be advantageous to sell long duration government bonds and purchase intermediate duration credit to maintain exposures to credit spread duration while reducing the interest rate duration. Replace long duration bonds with return-seeking fixed income such as bank loans, complex credit and direct loans. There are a variety of different types of return-seeking fixed income that could be suitable for this role. Many of them are both more complex and less liquid than traditional fixed income investments. However, they typically have much higher yield often by several percentage points, with much of this translating to higher potential returns. Often these instruments are based on floating rates or have other provisions that make them low duration, so they can be an effective way to reduce duration. Further, there are structural dislocations in fixed income markets that make us find some of these opportunities attractive. Maintain physical long duration bonds, but reduce the duration with derivatives. One way to implement this is by holding physical long credit bonds, and shorting long duration Treasury futures. In addition to allowing plan sponsors who already own long credit to avoid round-trip transaction costs of selling their long credit and buying it back later, this approach can also help plan sponsors maintain high credit spread duration and low interest rate duration. Further, it allows the plan sponsor to lock in the credit spread at the long end of the curve, which is significantly higher than the credit spread for intermediate duration. The figures below illustrate why plan sponsors might want to do this. As of June 30, 2012, Figure 4 shows that credit spreads for intermediate duration credit were 1.7% versus 2.3% for long credit. Figure 5 shows that this 0.6% difference is near a historical high, suggesting the advantage of plan sponsors using this strategy to lock in to higher spread level. Figure 4 Figure 5 6

8 Conclusion While regulatory changes such as MAP-21 are certainly important, it is equally important for plan sponsors to remember that long-term obligations have not changed: plans must pay the benefits promised to participants. Though Congress and other regulatory bodies can create temporary rules that change how that obligation is measured and financed, sponsors should keep in mind the true economics of the plan as well as the regulatory environment they are in when developing risk management strategies. Although the new legislation doesn t change plan accounting or the fundamental economics of plan costs, the rules do lengthen the time many plans will remain underfunded and reduce the near-term potential for interest rate risk to cause higher contribution requirements. While this will have a minimal effect on the preferred investment strategies for some plans, many will see a stronger case for adopting a hedge path that maintains low duration fixed income when rates are low and uses interest rate triggers to lengthen duration as rates rise. This strategy can be an effective way to fine tune risk exposures within the current market environment and new regulatory changes. 7

9 Contact Information Eric Friedman, FSA, EA, CFA Hewitt EnnisKnupp Phil Kivarkis, FSA, EA, CFA Hewitt EnnisKnupp Armand Yambao, FSA, EA Hewitt EnnisKnupp About Hewitt EnnisKnupp Hewitt EnnisKnupp, Inc., an Aon company, provides investment consulting services to nearly 500 clients in the U.S. with total client assets of over $2 trillion. Our more than 200 investment consulting professionals a result of the merger of Hewitt Investment Group, Ennis, Knupp & Associates, and Aon Investment Consulting advise endowment, foundation, not-for-profit, corporate and public pension plan clients ranging in size from $3 million to over $740 billion. For more information, please visit 8