December 2017 Pension Finance Update

January 02, 2018

Pension funded status dipped in December, but most plans enjoyed improved funded status for the year. Stock markets enjoyed their best year since 2013, but long-term interest rates pushed remorselessly lower and credit spreads narrowed to lows not seen since before the 2008 financial crisis, driving up pension liabilities.

Overall, the experience was good news for both model plans we track1: traditional Plan A lost 1% in December but ended the year more than 3% ahead, while the more conservative Plan B dropped a fraction of 1% last month, ending 2017 up more than 1%.

Assets

Stocks mostly gained modestly in December, capping an excellent year: the S&P 500 gained more than 1%, the NASDAQ added less than 1%, the small-cap Russell 2000 lost less than 1%, and the overseas EAFE index was up almost 1% in December. For the year, the Russell 2000 gained more than 14%, the S&P 500 earned 22%, the EAFE was up 24%, and the NASDAQ increased more than 28%.

A diversified stock portfolio gained less than 1% during December and more than 22% for the year.

Bonds added close to 1% in December on the strength of interest rates edging about 0.1% lower. A diversified bond portfolio earned 5%-9% during 2017, with longer duration bonds and corporates doing best.

Overall, our traditional 60/40 portfolio gained almost 1% in December and ended 2017 up 14%, while the conservative 20/80 portfolio gained 1% last month and more than 9% during 2017.

Liabilities

Pension liabilities (for funding, accounting, and de-risking purposes) are now driven by market interest rates. The graph on the left compares our Aa GAAP spot yield curve at December 31, 2016, and December 31, 2017, and it also shows the (small) movement in the curve last month. The graph on the right shows our estimate of movements in effective GAAP discount rates for pension obligations of various durations during 2017:

Interest rates moved down about 0.1% in December, pushing pension liabilities up 1%-2% during the month.

Corporate bond rates fell almost 0.5% during 2017, driving liabilities 8%-12% higher during 2017, with long duration plans seeing the biggest increases.

Summary

At the beginning of the year, few prognosticators anticipated stocks would earn 20%+ this year, and few foresaw long-term interest rates falling by 0.5%, pushing pension liabilities higher and leaving rates only 0.25% above all-time lows seen in the summer of 2016. But that’s what happened.

On balance, this combination produced the best year for pension finance since 2013.

The graphs below show the movement of assets and liabilities for our two model plans during 2017:

Looking Ahead

Congress passed a budget in 2015 that includes a third round of pension funding relief since 2012. The upshot is that pension funding requirements over the next couple years will not be appreciably affected by current low interest rates (unless these rates persist). Required contributions for the next few years will be lower and more stable than under prior law.

Discount rates moved down about 0.1% last month. We expect most pension sponsors will use effective discount rates in the 3.4%-3.9% range to measure pension liabilities right now. Employers with calendar year financial statements are looking at the lowest rates ever for measuring liabilities at the end of 2017.

The table below summarizes rates that plan sponsors are required to use for IRS funding purposes for 2017, along with estimates for 2018. Pre-relief, both 24-month averages and December ‘spot’ rates, which are still required for some calculations, such as PBGC premiums, are also included.

1Plan A is a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, while Plan B is a cash balance plan (duration 9 at 5.5%) with a 20/80 allocation with a greater emphasis on corporate and long-duration bonds. We assume overhead expenses of 1% of plan assets per year, and we assume the plans are 100% funded at the beginning of the year and ignore benefit accruals, contributions, and benefit payments in order to isolate the financial performance of plan assets versus liabilities.

October Three Consulting, LLC is a full service actuarial, consulting and technology firm that is a leading force behind the reemergence of defined benefit plans across the country. A primary focus of the consultants at October Three is the design and administration of comprehensive retirement benefits to employees that minimize the financial risks and volatility concerns employers face.

Through effective plan design strategies October Three believes successful financial outcomes are achievable for employers and employees alike. A critical element of those strategies is the ReDB® plan design. The ReDefined Benefit Plan® represents an entirely new, design-based approach to retirement and to the management of both the employer’s and the employee’s financial risk, focusing on maximizing financial efficiency and employee value.

For more information:

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