July 2017 Pension Finance Update

Strong stock markets have buoyed pension sponsors this year, overcoming lower interest rates to produce improvements in pension funded status, and July saw a continuation of this trend. Both model plans we track1 enjoyed modest (less than 1%) improvement last month and remain in the black for the year so far. Traditional Plan A is now up more than 2% this year, while the more conservative Plan B is ahead 1% through the first seven months of 2017.

Assets

Stocks posted their ninth consecutive winning month in July: the S&P 500 gained 2%, the NASDAQ was up more than 3%, the small-cap Russell 2000 gained less than 1%, and the overseas EAFE index earned almost 3%. For the year, the NASDAQ is 18% ahead, the S&P 500 is up almost 12%, the Russell 2000 is up almost 6%, and the EAFE index is up 17%.

A diversified stock portfolio gained more than 2% in July and is now up 13% through the first seven months of 2017.

Treasury bonds were flat during July, while corporate bonds earned close to 1%, as credit spreads tightened to their narrowest point since the summer of 2014. Treasuries have gained 2%-3% and corporates have earned 4%-7% through July. A diversified bond portfolio has earned 3%-5% so far during 2017, with longer duration bonds and corporates doing best.

Overall, our traditional 60/40 portfolio gained 1%-2% in July and is now up 8%-9% for the year, while the conservative 20/80 portfolio was up 1% last month and is now 6% ahead 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 July 31, 2017, and 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 durations during 2017:

Long-term yields moved down less than 5 basis points during July and are now about 0.3% lower than where they ended 2016.

The move pushed pension liabilities up about 1% in July, leaving liabilities about 5%-7% higher during 2017, with long duration plans seeing the biggest increases.

Summary

Strong stock markets and lower interest rates have pushed both pension assets and liabilities up so far during 2017, with asset growth outpacing liability growth modestly.

The graphs below show the movement of assets and liabilities for our two model plans during the first seven months of 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 several 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 a couple basis points last month. We expect most pension sponsors will use effective discount rates in the 3.5%-4.1% range to measure pension liabilities right now.

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.