In this article we update our analysis of critical defined benefit finance issues in light of interest rate and asset market developments since late May 2020.
We begin by noting two developments in Federal Reserve monetary policy that will directly affect interest rates.
Fed to continue low-interest rate monetary policy
The Fed Open Market Committee has announced it will keep the Fed funds rate near 0% through 2022. In its June 10, 2020, statement, the FMOC said “The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
The Fed has begun buying corporate bonds. On June 15, 2020, the Fed announced that it “will begin buying a broad and diversified portfolio of corporate bonds to support market liquidity and the availability of credit for large employers.” This Fed action was “established with the approval of the Treasury Secretary and with $75 billion in equity provided by the Treasury Department from the CARES Act.”
Both Fed actions are likely to put downward pressure on the corporate interest rates used to value DB plan liabilities.
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Now let’s turn to a consideration of the effect of changes in the interest rate and asset markets on three principle DB finance issues – minimum funding, PBGC premiums, and settlement/de-risking.
Minimum funding: Our key conclusions, first discussed in our March 24, 2020, article, have not changed. Funding requirements for 2020 for a calendar year plan were locked in as of January 1, 2020. Interest rate declines – which are becoming the key DB finance “problem” produced by the current markets – won’t show up in minimum funding numbers until 2023.
The trends we observed in our last article (at the end of May) – declining interest rates and improving asset results – are persisting:
Interest rates remain at or near all-time lows. Market interest rates have stabilized since the end of April, with higher Treasury yields being offset by partial “re-normalization” of credit spreads. As of this writing, market rates remain about 50 basis points lower than at the end of 2019. That is on top of a nearly 100 basis point decline in 2019.
Back at the beginning of 2019, we were projecting that market rates would be higher than HATFA rates as early as 2023. Because of continued 2020 rate declines, it looks like sponsors will, however, be “stuck with” lower HATFA 25-year average rates for the foreseeable future. (In our first 2020 article on these issues we discussed the interaction of HATFA rates and market rates in detail.) As the chart below shows, HATFA rates will, per the statute, begin to “ratchet down” by 5 percentage points per year beginning in 2021, resulting in lower valuation interest rates and higher liability valuations.
(We note that there is a proposal in Congress to significantly increase current funding relief.)
Second, asset performance has continued to improve since March 2020 lows. Equities were down around 30% at the end of March. They were down only around 10% at the end of May. They are as of this writing off only around 3%. And bonds are up 8% on the year.
Many plans’ asset portfolios will be flat or a little up for the year. This trend is particularly significant for plan funding because asset performance generally has a more immediate effect (than interest rates) on plan funding. Thus, near-term asset-driven minimum funding issues are (in the current situation) unlikely to be a problem for many plans.
To the extent a plan does have 2020 asset losses, they will have no effect on 2020 funding. They may, however, increase a plan’s funding shortfall and minimum funding requirements for 2021. That shortfall will generally have to be paid for beginning in 2022, starting with 2022 quarterlies and ending with the September 2022 residual contribution for 2021. Sponsors that want or need to stay above 80% funding, e.g., to avoid benefit restrictions, may as a result of 2020 asset losses (if any) have to make contributions in 2021.
PBGC premiums: Unlike minimum funding, which is subject to HATFA 25-year average interest rate stabilization, PBGC variable-rate premiums are determined based on a liabilities-minus-assets calculation of “unfunded vested benefits” (UVBs) that reflects market interest rates (entirely or based on 24-month average rates at most) and the fair market value of assets. Thus, e.g., 2021 variable-rate premiums will reflect 2020 interest rates and assets.
The significant 2020 interest rate declines are likely to trigger or increase the payment of variable-rate premiums (often significantly) for many sponsors in 2021.
We estimate that a duration 12 plan, with a 60/40 equity/fixed income portfolio, that (on a fair market value basis) was 100% funded on January 1, 2020, is about 93% funded as of June 23, 2020. For a $100 million dollar plan, this translates to $7 million in unfunded liabilities and a 2021 variable-rate premium of $315,000. That is down from our estimate of $500,000 for the same plan as of March 23, 2020.
Our March 2020 article details these issues and discusses strategies for reducing PBGC premiums.
We also note that for some plans the most significant decision will be whether to elect the Alternative method for calculating UVBs for 2020. We discussed that issue in our May 2020 article. For most sponsors, the time for considering this issue will be August-September 2020, and we will provide a comprehensive review of it at that time.
Settlement: At the beginning of May we posted an article about the effect of changes in market interest rates on the settlement decision – whether to pay out (as a lump sum or annuity) current DB benefits. Summarizing, the four key datapoints affecting the settlement decision, in the current context, are:
1. For most plans, the (favorable-to-sponsors) spread between lump sum valuation rates and current market rates continues to hold – lump sum valuation rates are currently around 70 basis points higher than market rates.
2. The savings in PBGC premiums may be considerable and have increased in 2020 as interest rates have declined.
3. Many participants need cash now and may be eligible for favorable tax treatment. And, indeed, late 2019 rates produce higher lump sums than in any previous year.
4. The one wild card facing sponsors is the direction of future interest rates. In this regard, see our discussion (at the top) of recent Fed policy announcements.
Our earlier article provides details on each of these issues.
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We would observe that the interest rate and asset markets appear to be stabilizing and that it looks like we are living with a “new normal” of lower rates. The imponderable is whether the extraordinary stimulus efforts will – notwithstanding the efforts of the Fed – result in increased inflation.
We intend to regularly update these key DB finance datapoints for the duration of the current crisis.