May 2016 Pension Finance Update

Higher interest rates and higher stock prices improved pension finances modestly in May. Both model pension plans we track1 gained a bit of ground last month. Plan A improved 1% in May, but remains down more than 6% so far in 2016, while Plan B picked up less than 1% last month, but is still down 3% year to date:

Assets

Stocks enjoyed a positive month in May: the S&P 500 added almost 2%, the NASDAQ gained more than 3%, the Russell 2000 was up more than 2%, and the overseas EAFE index was flat during the month. For the year, the S&P 500 is up more than 3%, the Russell 2000 is ahead 2%, the EAFE index is flat, and the NASDAQ is off 1%.

A diversified stock portfolio gained close to 2% during May and is now up almost 2% for the year.

Short-term bonds lost a fraction of 1% last month, as did long-term corporate bonds, while long-term Treasuries gained fractionally due to flattening of the Treasury curve during May. For the year, bonds are now 4%-6% ahead, with longer duration bonds and corporates doing best.

Overall, our traditional 60/40 portfolio gained 1% in May and is now up more than 2% for the year, while the conservative 20/80 portfolio was flat last month and remains up 5% during 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 May 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:

Treasury yields edged down a few basis points during May and are down close to 0.50% this year. Meanwhile, corporate bond yields rose about 0.05% last month, but are still down more than 0.40% in 2016, as credit spreads widened last month.

The move pushed pension liabilities down close to 1% last month; liabilities are now 8%-10% higher than at the end of 2015, with long duration plans seeing the biggest increases.

Summary

The uptick in interest rates last month was the first such monthly increase this year, providing pension sponsors some relief (along with modest increases in stocks) in what is shaping up as a difficult year. Through five months, assets have gained some ground, but liabilities have grown faster on account of rates falling for most of the year so far.

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 moved up a few basis points last month. We expect most pension sponsors will use effective discount rates in the 3.5%-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.