September 2016 Pension Finance Update

Pensions enjoyed modest improvement in funded status last month, but remain underwater during 2016 through three quarters. Both model pension plans we track1 improved by less than 1% in September. For the year, Plan A is down 5% and the more conservative Plan B is down less than 1%:

Assets

Stocks mostly edged up in September: the S&P 500 was flat, but the NASDAQ added 2%, the small-cap Russell 2000 earned 1%, and the overseas EAFE index was up more than 1%. For the year, the S&P 500 is up almost 8%, the NASDAQ is up 6%, the Russell 2000 is up 11%, and the EAFE index is up 2% through three quarters.

A diversified stock portfolio gained less than 1% during September and is now up almost 7% through the first three quarters of 2016.

Interest rates moved up a bit last month, mostly at longer maturities, producing losses of less than 1%, on bond portfolios in September. For the year, bonds remain up 8%-10%, with longer duration bonds enjoying the best results.

Overall, our traditional 60/40 portfolio gained a fraction of 1% during September and is up more than 7% so far this year. The conservative 20/80 portfolio was down fractionally last month but remains up almost 10% through the first three quarters 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 September 30, 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 were up a couple basis points at short maturities and 0.1% at longer maturities last month, providing downward pressure on pension liabilities, which fell less than 1% during September. Rates remain near all-time low levels, however, and pension liabilities remain 10%-14% higher than at the end of 2015, with long duration plans seeing the biggest increases.

Summary

The stock market has bounced back from losses in early 2016, posting modest gains so far this year, and bonds have done even better on the strength of lower interest rates. These gains have not kept up with increase in pension liabilities however, which are driven by the same decline in interest rates, which remain near record low levels.

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 0.1% for longer duration plans last month. We expect most pension sponsors will use effective discount rates in the 3.2%-3.9% range to measure pension liabilities right now. These rates are as low as we’ve ever seen.

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.