October 2016 Pension Finance Update

October was a down month for investors, but pension sponsors were able to tread water, as the impact of higher interest rates on pension liabilities offset asset losses. Both model pension plans we track1 saw basically flat results on the month. Through October, Plan A is down almost 5% and the more conservative Plan B is down almost 1% on the year:

Assets

Stocks lost ground in October: the S&P 500, NASDAQ, and overseas EAFE index all lost about 2%, while the small-cap Russell 2000 fell 5%. For the year, the S&P 500 is up 6%, the NASDAQ is up 4%, the Russell 2000 is up 6%, and the EAFE index is flat through the first ten months of the year.

A diversified stock portfolio lost more than 2% during October but remains up more than 4% on the year.

Interest rates saw their biggest jump in the year in October, producing losses of 1%-2% on bond portfolios in October. For the year, bonds remain up 7%-8%, with longer duration bonds enjoying the best results.

Overall, our traditional 60/40 portfolio lost 2% during October, but remains up more than 5% so far this year. The conservative 20/80 portfolio also lost 2% on the month, but remains up almost 8% through the first ten months of 2016.

Liabilities

Pension liabilities (for funding, accounting, and de-risking purposes) are now driven by market interest rates. The graph on the left compares Treasury STRIPs yields at December 31, 2015 and October 31, 2016, and also shows the movement in rates last month. The graph on the right shows our estimate of movements in effective GAAP discount rates for pension obligations of various duration during 2016:

Interest rates jumped more than 0.2% during October, reducing pension liabilities by 1%-2%. Rates have moved higher since hitting all-time lows in July, but pension liabilities remain 8%-12% higher than at the end of 2015, with long duration plans seeing the biggest increases.

Summary

Interest rates remain 0.5% lower than at year-end 2015, so growth in pension liabilities continues to outpace asset growth through the first ten months of 2016.

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

Looking Ahead

The Obama Administration and Congressional leaders passed a budget last fall 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 edged up 0.2% for longer duration plans last month. We expect most pension sponsors will use effective discount rates in the 3.4%-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 2016, along with estimates for 2017. 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 cash balance plan (duration 9 at 5.5%) with a 20/80 allocation with a greater emphasis on corporate and long-duration bonds. For both plans, we assume the plan is 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.