February 2018 Pension Finance Update

February was a difficult month for investments, but a so-so month for pension finance due to higher interest rates. Both model pension plans we track1 were close to flat last month. For the year, Plan A remains 5% ahead, while Plan B is up 1%:

Assets

Stocks suffered their worst month in over two years in February, breaking a 15-month winning streak in the process. The S&P 500 lost almost 4%, NASDAQ dropped 2%, the small-cap Russell 2000 fell 4%, and the overseas EAFE index slipped almost 5%. For the year, the NASDAQ remains up more than 5%, the S&P 500 has gained 2%, the EAFE index is flat, and the Russell 2000 is down more than 1%.

A diversified stock portfolio lost 3%-4% in February but remains ahead close to 2% for the year.

Bonds lost 1%-2% during February, as interest rates rose 0.2% and credit spreads widened about 0.05%. Corporate bonds and long-duration bonds suffered the worst last month. For the year, a diversified bond portfolio has lost 3%-4%

Overall, our traditional 60/40 lost almost 3% in February and is down almost 1% for the year, while the conservative 20/80 portfolio fell by more than 2% and is now down 3% after the first two months of 2018.

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, 2017, and February 28, 2018, and it also shows the 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 duration during 2018:

Corporate bond yields rose more than 0.2% at most maturities in February, pushing pension liabilities down 2%-3% on the month. For the year, liabilities are down 4%-5% – a bit less for short duration plans, a bit more for long duration plans.

Summary

In the first two months of 2018, interest rates have risen by close to 0.5%. For the total US private pension system, this translates to about $100 billion in lower liabilities, equal to about two years of contributions by plan sponsors. This is the story of improved pension finances so far in 2018.

The graphs below show the movement of assets and liabilities for our two model plans so far this year:

Looking Ahead

Congress passed a budget in 2015 that includes a third round of pension funding relief since 2012. The persistence of historically low interest rates, however, means that pension sponsors that have only made required contributions will see contributions ramp up in the next few years as the impact of relief fades (barring an increase in long-term rates).

Discount rates rose 0.2% again last month. We expect most pension sponsors will use effective discount rates in the 3.9%-4.4% range to measure pension liabilities right now.

The table below summarizes rates that plan sponsors are required to use for IRS funding purposes for 2018, along with estimates for 2019. 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.