July 2020 Pension Finance Update

July was a mixed month for pension finance, with strong stock markets offsetting the impact of new all-time low interest rates. Both model plans we track[1] were close to even last month, with Plan A slipping 1% and Plan B treading water during July. For the year, Plan A is down 9% and Plan B is down 2% through the first seven months of 2020:

Assets

Stocks posted a fourth consecutive positive month in July. A diversified stock portfolio is now back to even for 2020, after being down more than 20% at the end of the first quarter.

Treasury rates fell about 0.2% last month, while corporate yields dropped more than 0.3%, as credit spreads continued to “normalize”. As a result, Treasuries gained about 1%-2%, while corporate bonds added 3%-6% in July. A diversified bond portfolio gained 2%-4% last month and is now up 11%-13% through the first seven months of 2020, with long duration and Treasuries outperforming.

Overall, our traditional 60/40 portfolio gained 4% in July and is now up 4% for the year, while the conservative 20/80 also gained 4% last month and is now up 9% through the first seven months of 2020.

Liabilities

Pension liabilities (for funding, accounting, and de-risking purposes) are driven by market interest rates. The first graph below compares our Aa GAAP spot yield curve at December 31, 2019 and July 31, 2020, and it also shows the movement in the curve last month. The second graph below shows our estimate of movements in effective GAAP discount rates for pension obligations of various duration during 2020:

Corporate bond yields fell 0.3% to new all-time lows last month. Through the first seven months of 2020, liabilities have increased 11%-17% for most plans, with long duration plans seeing the largest increases.

Summary

What looked like a bear market for stocks earlier this year now looks more like one more “turn of the screw” for lower long-term interest rates, a trend that has run for almost 40 years, encompassing the career of most people now working and bedeviling pension finance all century. The graphs below show the movement of assets and liabilities for our two model plans during the first seven months of 2020: 

Looking Ahead

Pension funding relief has reduced required plan funding since 2012, but under current law, this relief will gradually sunset. Given the current level of market interest rates, it is possible that relief reduces the funding burden through 2030, but the rates used to measure liabilities will move significantly lower over the next few years, increasing funding requirements for pension sponsors that have only made required contributions.

2020 experience, if it persists, will not increase required contributions until 2022, compounding higher funding requirements due to the fading of funding relief. There is some chance we get more relief this year, but at this point it’s too soon to say for certain. 

Discount rates moved lower again last month. We expect most pension sponsors will use effective discount rates in the 2.1%-2.5% range to measure pension liabilities right now.

The table below summarizes rates that plan sponsors are required to use for IRS funding purposes for 2020, along with estimates for 2021. 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.