July 2018 Pension Finance Update

Pensions continued their upward march in July – stocks were up and discount rates held steady last month – and 2018 is shaping up to be one of the best years this century for pension finance. Both model plans we track [1] gained ground last month – traditional Plan A improved more than 1% while the more conservative Plan B gained less than 1%. For the year, Plan A is almost 8% ahead, while Plan B is up more than 1%:

Assets

Stocks were up during July: the S&P 500 gained almost 4%, the NASDAQ and small-cap Russell 2000 improved almost 2%, and the overseas EAFE index rose 3%. Through the first seven months of 2018, the NASDAQ is up 11%, the Russell 2000 is ahead more than 9%, the S&P 500 is up more than 6%, and the EAFE index is down less than 1%.

A diversified stock portfolio gained 3% in July and ended July up 6% for the year.

Treasury bonds lost close to 1% last month as rates moved up 0.1%, but corporate bonds earned a fraction of 1% as these rates held steady and credit spreads decreased 0.1% during July. Through July, a diversified bond portfolio remains down 3%-4%, with long duration bonds and corporates doing worst.

Overall, our traditional 60/40 gained more than 1% in July and is now up 2% for the year, while the conservative 20/80 portfolio gained less than 1% last month but is still down more than 2% through the first seven 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 July 31, 2018, and it also shows the (tiny) 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 were flat at most maturities during July, pushing pension liabilities up less than 1% on the month. For the year, liabilities are down 4%-6%, with long duration plans seeing the biggest drops.

Summary

Higher interest rates (corporate yields up 0.60% so far this year) and positive stock market returns have combined to produce steady improvement in pension finances so far during 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 didn’t move much last month. We expect most pension sponsors will use effective discount rates in the 4.0%-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.

[1]Plan A is a traditional plan (duration 12 at 5.5%) with a 60/40 asset allocation, while Plan B is a largely retired 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.