2018 Pension Plan Report Card – C+ Year
Last year was a so-so year at best for most plan sponsors. For most of the year things looked good but by the end of 2018 there were few things to celebrate. The good news was that interest rates were up year-over-year, but, in December, rates gave up some of the year’s increases and the claw back continued into the first few weeks of 2019. Volatile equity markets made for an overall bumpy ride, and again December proved to be a disaster. More than likely plan sponsor will see some funded status deterioration in 2018 largely driven by the December markets. The good news though is that equity markets have already started to rebound in 2019 (for now at least).
This article looks at and grades the various drivers of pension plan funded status that occurred in 2018. When plan sponsors pull these factors together they will find opportunities in 2019 to manage volatility, and execute pension risk transfers to lower plan risk and cost. Finally, with the looming sunset of funding relief sponsors will want to have an eye towards future cash calls.
Market / Investment Performance: D
Risk assets (e.g. equities) started the year strongly. However, volatility ensued quickly with concerns over monetary policy, inflation fears, geopolitical concerns, and signs of economic slowdown across the globe. Ultimately, most global markets ended the year in negative territory and December ended up being the worst month for U.S. stocks since the Great Financial Crisis.
The year ended with the S&P 500 down 4.4%. Developed international equities (MSCI EAFE Index) were down almost 14% and emerging market equities were down about 15%. An appreciating dollar weighed on international markets and particularly emerging markets.
Bond portfolios had poor returns this year as rising rates reduced values. U.S. Treasury interest rates increased. The interest rate curve flattened during the year; short term rates increased more than the long end of the curve as the Fed increased the federal funds rate four times. Consequently, the 3 month rate increased by over 1%, while the longest part of the curve (the 30 year treasury rate) increased by only 0.3%. Volatility also increased in the bond markets and credit spreads widened. This led to higher quality fixed income outperforming lower quality bonds. Intermediate duration bonds ended 2018 flat. High yield and emerging market debt decreased -2.1% and -2.5%, respectively. Long duration corporate bonds decreased approximately 7% and long duration U.S. Treasuries decreased almost 6%.
Plan sponsors with the traditional 60% equity/40% aggregate fixed income portfolios generally saw their portfolios return down about 5%, while those with 60% equity/ 40% liability matching bonds would have seen their portfolios return down even further around 8%.
Interest Rates (Accounting): B+ (higher than last year)
From the start of 2018, high-quality corporate bond rates that are used for valuing liabilities for accounting purposes were on the climb. This climb continued throughout the year reaching peak levels in October and November. At that point in time discount rates had effectively increased close to 0.85% year-to-date. These rates were just slightly below the 5-year high for discount rates that we saw in the early months of 2014.
Unfortunately, with the market turmoil in December, rates made a sharp decline pulling back around 0.20% by year-end. Even with the decline in December, on the whole 2018 was a great year for plan sponsors with discount rates generally up around 0.65%. While a 0.65% rise in rates might normally earn a low A, December’s pull back makes us a tough grader.
Interest Rates (Funding): C (once again they’ve come down)
The underlying yield curve used in determining minimum funding interest rates made a parallel shift down from the yield curve as of the end of 2017.
Because of the 10% corridor around the 25-year historical average interest rates continues to be in effect, the actual segment rates for calculating minimum funding liabilities are still above the yield curve levels. That said, as in prior years, the 24-month average segment rates with the corridor constraint are down from the beginning of 2018. In general this decline in the segment rates will produce an effective rate that is about 0.20% lower for 2019 and leave sponsors with higher minimum funding liabilities all else equal.
Mortality Assumptions: B (lower liabilities again)
Similar to the last four years, the Society of Actuaries (SOA) published an updated mortality improvement projection scale in the fall of 2018. The update comes as a result of updated data included in their model along with model methodology tweak meant to produce more stable results over time.
What this update means is that sponsors can expect lower accounting liabilities on the order of 0.2% – 0.6% depending on the demographics of their participants.
Legislative – B (status quo once again)
While there have been several proposals floating around Congress that would affect pension plans, there was once again no major legislation passed during the year. The legislation that has been discussed would have fairly insignificant implications for corporate pension plan sponsors with maybe the most impactful being a raise in the mandatory cashout threshold.
Pension Risk Transfers: A (another record year for insurers)
Once again, the annuity buy-out market continued its exponential growth with 2018 premiums expected to be around $27B. This is up from the record year in 2017 with $23B in premium sales. One of the more significant transactions of the year was the $6B FedEx deal that landed in Q2. Through this transaction FedEx transferred the benefit obligations of approximately 41,000 retirees and beneficiaries to MetLife.
2019 has already started off with a bang with Lockheed Martin announcing two transactions totaling $2.6B ($1.6B buy-out and a $800M buy-in), and Weyerhaeuser offloading $1.5B.
The annuity purchase market will continue to provide opportunity to plan sponsors looking to shrink the size of their pension plan and subsequently reduce administrative costs and potential funded status volatility. Pricing is still very attractive with most retiree only deals coming in around the accounting liability for sponsors that use realistic assumptions for mortality and discount rates. (Check out our Pension Plan Annuity Purchase Update for the latest insights on the pension annuity transfer market.)
Thoughts Going Into 2019:
- Funded status volatility control – With many plan sponsors grappling between the trade-off of interest rate hedging and equity return, managing funded status volatility in today’s market environment will prove challenging. As we discussed during 2018, there are strategies that plan sponsors should consider to limit their overall funded status volatility through the use of equity derivatives and liability matching assets. These strategies, when designed appropriately, can help sponsors manage interest rate risk along with equity risk for more predictable funded status outcomes (see Pension Investing – Next Generation of Glide Paths).
- Shrink-the-ball opportunities (AKA Pension Risk Transfers) – 2019 is currently a good year to consider a lump sum cashout window for vested terminated participants. For most plans, the rates that apply for calculating lump sums will be based on rates as of last fall when they were at close to 5-year highs. With rates pulling back so far in 2019, the difference in lump sum payouts and balance sheet liabilities should prove favorable to plan sponsors.
- Keep your eye on future cash calls – We only have a couple of years left on the interest rate funding relief for minimum funding purposes. As that corridor starts to expand in 2021, sponsors could see dramatic increases in required contributions starting in 2022 (due to contribution timing rules). It is extremely important that plan sponsors understand how much their contributions could increase and adequately prepare for those increases in their future budgets.
The poor investment returns suffered by most plan sponsors in 2018 more than offset the reduction in liabilities due the rise in corporate rates. But higher rates have created opportunities for sponsors who want to continue to lower the risk and cost of their plans in 2019.