January 2016 Pension Finance Update
For the second straight year, pension sponsors suffered a significant setback in January, due to a combination of declining stock markets and lower long-term interest rates. Both model pension plans we track were down last month: Plan A dropped more than 6%, while Plan B lost almost 3%:
Equity markets around the world were sharply lower in a volatile January: the S&P 500 and overseas EAFE index both lost more than 3%, while the NASDAQ and small-cap Russell 2000 both dropped close to 8%.
A diversified stock portfolio lost more than 6% in January.
Bonds enjoyed gains in January due to lower interest rates, adding 2%-3% on the month, with longer duration bonds doing best, and Treasuries outperforming as credit spreads widened during the month.
Overall, our traditional 60/40 portfolio lost 3% in January, while the conservative 20/80 portfolio was even for the month.
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 January 31, 2016. The graph on the right shows our estimate of movements in effective GAAP discount rates for pension obligations of various duration during 2016:
The move pushed pension liabilities 3%-4% higher in January, with long duration plans seeing the biggest increases.
January was another reminder that in the current economic climate, volatility can produce short-term pain for pension sponsors from both lower stock prices and lower interest rates.
The graphs below show the movement of assets and liabilities for our two model plans:
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 moved down about 0.2% last month. We expect most pension sponsors will use effective discount rates in the 3.7%-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 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.