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Looking Ahead (Again): The Implications of Market Volatility on Defined Benefit Plans

Major equity indices have provided positive returns through the first three quarters of 2010 thanks in large part to a strong September. Through September 30, the Dow was up 3.43% while the S&P 500 recorded a 2.21% increase (year-to-date, without regard to dividends). Fixed income investments saw stronger performance as a result of falling interest rates. Many plan sponsors have seen year-to-date returns that are in line with accounting assumptions.

Despite positive investment returns, many defined benefit plan sponsors could be facing increased funding and accounting shortfalls by the end of the calendar year. While a modest September rally may be cause for guarded optimism, the fact is corporate bond yields have continued to fall throughout the past 18 months. In fact, despite some “noise” along the way, the Citigroup Pension Index has seen a decline in its published benchmark of 220 basis points (bps) since the first quarter of 2009, including a drop of nearly 100 bps during the past six months.

Financial Accounting Disclosures (FAS)

Similar to funding liabilities, financial accounting liabilities are based on discounting expected future pension payments. The discount rate used for these purposes is based on the current yield for high quality, long-term corporate bonds of similar duration (typically, corporate bonds rated AA or better).

As discount rates decrease, liabilities increase. Based on changes to these rates during the past year, plan sponsors will likely find it difficult to justify the use of a fiscal year-end discount rate as high as that used for prior year fiscal disclosures. The graph below compares Citigroup Pension Liability Index yields from December 2009 with the most recent rate information for September 2010.

Individual spot rates have fallen for every discount period within the index. The change continues to be most dramatic during years 5-15 where the average decrease is more than 1.3%. While Citigroup’s published yield has fallen only 80bps (0.80%) since last December, it appears that many plan sponsors could face larger reductions at fiscal year-end as average individual rates within the portfolio have fallen closer to 1.00%. Frozen plans and plans with higher average participant ages could face even larger discount rate reductions as the expected benefit payment structure of these plans typically results in liability patterns that are more affected by the steep changes to years 5-15 of the yield curve.

Based on this information, defined benefit plan sponsors continue to face year-end liability increases of 8% to 15% - an increase that directly impacts Accumulated Other Comprehensive Income (AOCI) as an unfavorable equity adjustment.

2011 Funding Results

Under PPA, plan liabilities are calculated in a manner similar to that of the pricing of a bond. Both represent the present value of a stream of benefits payable in the future. In order to determine that value, future payments are discounted by a specific interest rate (the discount rate). The majority of sponsors with calendar year plans employed the segment-rate methodology to plan funding for 2010 (either switching back from or not electing to use the yield curve alternative for prior years) which utilizes a 24-month average of “spot” interest rates. Increases in the underlying corporate bond yields result in larger discounts, reducing plan liabilities.  Similarly, decreases in those yields produce larger plan liabilities.

For many plan sponsors, the 24-month averaging period which will determine the segment rates used for 2011 calendar plan year valuations runs from September 2008-September 2010. Rate information has been published for all 24 months that comprise that average and the results are less-than-desirable for calendar year plan sponsors.

 

	2010 Plan Year (Actual)	2011 Plan Year (Actual)
First segment rate	5.03%	3.78%
Second segment rate	6.73%	6.31%
Third segment rate	6.82%	6.57%

Similar to the Citigroup Pension Index above, the resulting segment rates decrease for all durations with a particularly significant reduction for the first segment rate (covering benefit payments made during the next five years).

These changes will impact plan liabilities differently depending on the nature of each plan’s demographics. Plans with more mature participant populations and those with significant retiree liability will see the most substantial increases. Based on a cross-section of our clients, plan sponsors should anticipate liability increases of 4%-6% when compared with unchanged segment rates. The results would be even more dramatic if combined with unfavorable plan year investment performance.

Looking even further ahead to 2012 plan years, prospects for a rate rebound won’t likely provide substantial relief because 13 of the 24 months used in the average have already passed. For comparison’s sake, the chart below illustrates projected 2012 plan year segment rates assuming no change in the current bond yield as well as a 50bp parallel upward shift ratably over the next 11 months.

 

	2011 Plan Year (Actual)	2012 Plan Year (no change)	2012 Plan Year (50bp change)
First segment rate	3.78%	2.03%	2.15%
Second segment rate	6.31%	5.12%	5.24%
Third segment rate	6.57%	6.16%	6.29%

In either scenario, the dramatic reduction in the first segment rate could create significant liability increases. Again, plans with more mature participant populations and those with significant retiree liability will see the most substantial increases. Addressing the potential challenges lower interest rates could create will be a top priority for plan sponsors and actuaries alike during the next 12-14 months.

Funding Relief

On June 25, 2010, President Obama signed the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act of 2010. Under the new law, calendar year defined benefit plan sponsors may elect to delay funding shortfalls related to two years covering the period 2009-2011 under one of two options.

The first option, frequently referred to as the “2+7” option, allows the plan sponsor to pay interest only for two years and then amortize the shortfalls over the traditional seven-year period. The second option simply extends the shortfall amortization period from 7 years to 15 years. To the extent an employer takes advantage of this relief, the method must be applied consistently (ie, you can’t elect “2+7” for one plan year and extend the amortization period to 15 years for another).

To the extent plan sponsors are considering funding relief (it comes with strings attached), anticipated 2011 plan year results must be factored into the decision. For example, calendar year plan sponsors may want to examine the benefits of applying relief in 2011 rather than 2010; off-calendar plan sponsors may benefit from applying funding relief to the 2010 and 2011 plan years rather than the 2009/2010 or 2009/2011 plan years. In addition, the magnitude of the potential savings and cash flow implications under each alternative must be analyzed. When handled correctly, these options may provide cashflow relief to plan sponsors waiting for underlying interest rates to bounce back to more “normal” levels.

Next Steps

We encourage additional liability-duration and yield analysis to better understand the specific impact these changes might have on your plan. When combined with forward-looking projections of fiscal year-end financial positions, plan sponsors will be able to avoid balance sheet surprises and better prepare updated 2011 and even 2012 budgets.

Recent market and interest-rate volatility may also provide the impetus for a more detailed examination of the plan’s investment policy. Liability-driven investing (LDI) is gaining a great deal of traction as an alternative to traditional DB plan portfolios in response to how plans are funded under PPA and accounted for under FASB Statement No. 158.

Please do not hesitate to contact us with any questions.

The materials created through August 2011 are when the professionals of Summit Financial were with Ogilvie Security Advisors Corp. The professionals of Summit Financial have not been with Ogilvie Security Advisors Corp. since August 31, 2011 and have no further affiliation with that organization.