Expectations that the stock market will continue to be volatile, combined with the effect of new mortality tables and an increase in the premiums that the Pension Benefit Guaranty Corporation (PBGC) charges sponsors of defined benefit (DB) plans, are together prompting sponsors to take an even more careful look at the funding levels of their pensions, experts say.
The pension funding status of the nation’s largest corporate plan sponsors finished the year at 82%, unchanged from the end of 2014, due in large part to a rise in interest rates offset by a weak global stock market, according to Willis Towers Watson. With the Dow Jones Average falling by 1,648 points in the first three weeks of 2016, the funding status would probably be lower at this point, says Alan Glickstein, senior retirement consultant at Willis Towers Watson, based out of Dallas. “If we were measuring pensions now instead of December 31, the picture would be more dismal,” he notes.
Furthermore, because the Internal Revenue Service (IRS) allows DB plans to discount future benefit payments to a present value using a 25-year average of bond rates rather than a two-year average, this could potentially be inflating the funding status for some plans, Glickstein says.
“Very few plans are 100% funded,” says Marc Lieberman, chairman of the public pensions/alternative investments group at Kutak Rock LLP in Scottsdale, Arizona. “There are plans with funding levels as low as 7%, but I would say most plans are in the 60% to 80% range.”
For corporate plans that are funded 80% or less, “getting their funding ratio up is an important goal,” says David Godofsky, head of the employee benefits and executive compensation group and a partner at Alston & Bird in Washington, D.C. Additionally, there are “a lot of government plans that are poorly funded, even as low as 30% or 20%.”
NEXT: The first step to improve funding
The best way to improve the funding status of a pension plan is to put more cash into the plan, “and to do that in a way that meets the goals of your corporate objectives,” says Ari Jacobs, global retirement solutions leader at Aon Hewitt in New York.
Brad Smith, partner and pension consultant at NEPC, an investment consulting firm with $560 billion in corporate pension assets under advisement, based in Atlanta, concurs: “We’ve had some very good market returns over the past three to five years. Through the end of 2015, the S&P 500 was up 15%. We do not expect those returns going forward. We really believe we are in a low-return environment, and in that scenario, the best thing a plan sponsor can do is to put more money into the program.”
With the discount rate change which amended the Pension Protection Act (PPA), the minimum funding requirements for pension plans is lowered, says Pierre Couture, head of customized solutions for multi-asset strategies and solutions at Voya Investment Management in New York. “To better fund their plan, sponsors need to contribute more than the minimum required because the average makes them appear better funded,” he says.
Another option available for plans that are not frozen is to “reduce the accrual of future benefits,” Godofsky says. There are pensions that offer “rich provisions for members [and therefore] have lower funding levels,” Lieberman concurs. “This is very popular among municipalities and states, and it might be done by adjusting future cost of living standards.” Along these lines, sponsors could also increase participants’ contributions, although this is more common among public plans than it is corporate plans, Godofsky says.
Some pension sponsors are borrowing to fund their plan, “which makes sense because interest rates are still low and it reduces the PBGC premium” on funding shortfalls, Couture notes. “Plus, the contributions and the loan are tax deductible.”
Public plans also have the option of issuing pension contribution bonds, Godofsky says. “That means you have traded future contributions into your pension plan for future payments on the bonds,” he says. However, there are risks to this strategy. “If you think your pension fund will earn a higher rate of return than the interest rate on the bonds, you come out ahead of the game. But if it doesn’t, then you have to pay the cost of servicing the bonds and make higher contributions to your defined benefit plan because the value decreased.”
Before a sponsor takes out a loan to fund their plan, they need to take a broader look at their overall use of cash, Glickstein says. “You have to look at the overall picture of the company and how many covenants they have on how many loans,” he says.
Of course, changing the investment strategy is an option at sponsors’ disposal. Lieberman believes that an increasing trend among plan sponsors might be to reduce their equity exposure through a risk-adjusted portfolio. “One well-managed plan has intentionally reduced their return because they want to reduce the risk of their entire portfolio,” he says. “They have intentionally designed their plan to do less well when equities rise and better when equities fall. They might earn 1% to 2% less than their peers when equities are booming, but when they are falling and their peers lose 20%, they might lose only 2%. Everybody in the field is cognizant that they have to reduce the volatility. These plans cannot bear these wild swings in their valuations.”
In addition, plans are increasingly interested in reducing their pension liabilities and improving the funded ratio by either paying lump sums to participants or purchasing group annuities and then adjusting the portfolios potential for income that matches pension liabilities, Couture says. Overall, he says, “With the help of their consultants, pension plan sponsors have done a good job of creating a glide path to reduce risk.”