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Some Perspectives for Corporate DB Plans

In this blog post we address two key questions facing corporate defined benefit (DB) plan sponsors in this volatile market environment:

  1. What does this market volatility mean for my corporate DB plan?
  2. Do these short-term moves overwhelm my long-term focus?

Q: My marked-to-market funded status just dropped by more than 10%…am I in trouble?

A: To answer the question, it is helpful to focus on three key areas:

Cash Impact

The recent market volatility is unlikely to change the near-term cash requirements for your pension plan. Why?

  1. Funding (i.e., IRS) liabilities are not marked-to-market for most corporate DB sponsors. Due to generous funding relief provisions that allow most corporate DB plans to smooth liability discount rates over a historical 25-year period, most corporate pension liabilities are still fairly insensitive to movements in market yields. Therefore, liability measurements are fairly stable for the next 2-3 years and are unchanged by recent activity. There could be more of an immediate concern for those plan sponsors that have elected to use unsmoothed IRS yield curves or segment rates in order to measure funding liabilities. For most plan sponsors, liabilities are likely to stay unchanged and therefore not increase the likelihood of a funding shortfall, which would impact the minimum required contribution. Plan sponsors that choose to fund to avoid PBGC variable premiums may see a drastic increase in cash requirements, but in difficult times they can simply choose not to make those discretionary contributions and pay the premiums instead.
  1. Funding rules also allow for actuarial asset values to be smoothed over a 24-month period. The asset losses sustained this day/week/month/year can be partially recognized over three years, further dampening the volatility of a funding shortfall and minimum required contribution.
  1. Contribution requirements are calculated only once a year on the actuarial valuation date, and so it is not daily or monthly volatility that matters as much as the level of yields and assets on that exact measurement date. While this may seem somewhat arbitrary, most pension plan valuation dates are Jan. 1, and therefore most plan sponsors have another 9+ months of market volatility (albeit positive or negative) to endure before that next measurement date arrives. Plan sponsors with April 1 valuation dates might be feeling more pressure—in that case, please see #1 and #2 above.

Balance Sheet Impact

Accounting rules remain somewhat marked-to-market for liability discount rates, and therefore plan sponsors with fiscal year measurement dates approaching in the near future might expect to see a significant increase in the pension liability. High-quality corporate bond discount rates (proxied by the FTSE Pension Discount Curve) fell ~100 bps over calendar year 2019 and another ~50 bps through February 2020. Adding the further drop in rates already experienced in March as well as double-digit equity market losses is likely to lead to an increased net pension liability on the balance sheet. Also note that durations increase when rates are very low so even if we “can’t” go too much lower, a further 50 bps decline in this environment is going to impact liabilities more than a 50 bps decline in a much higher interest rate environment. And unfortunately, convexity only exacerbates the issue. However, note that again, balance sheet assets and liabilities are measured only once a year on the disclosure date so luck is still at play for the plan sponsor.

Income Statement Impact

While lower discount rates would be expected to have an impact on some components of pension expense, most of the calculation allows for significant smoothing of investment and actuarial gains and losses. Therefore we can also expect a muted impact on the income statement for pension plan sponsors.

Q: So I’m probably OK for now. What about the next few years?

A: Let’s talk about plan finances first:

  • Cash: Funding relief is likely to continue to mitigate any cash pains in the next few years.
  • Balance Sheet and Income Statement: Sustained lower interest rates could cause net pension liabilities and pension expense to remain higher over a longer period of time.

What about the economy? Are prospects for growth now different? In the short term, yes.

Consensus forecasts are now pointing to recession, with a Q2 GDP decline in a range of -5% to -10% annualized, with further declines bleeding over into Q3 and perhaps Q4, before a rebound in 2021.

We view the current situation as a natural disaster on a global scale, with the “physical damage” coming from the temporary halt to production and consumption from the containment measures. The initial economic impact is far more sudden and deeper than a typical recession, but the bounce back will be quicker and stronger. We expect the equity markets will rebound quickly as well.

Long-term degradation to economic growth is not the likely case. The reversal of nine rate hikes and the return of quantitative easing (QE) changed the landscape for interest rates; the question is for how long? Will zero interest rate policy (ZIRP) and QE linger just like they did after the Global Financial Crisis (GFC)? A yield curve anchored on zero short rates suggests 10-year Treasury yields normalizing to 2%. A V-shaped recovery suggests lingering ZIRP and QE would be unnecessary, and we’ll move back toward rate normalization. Callan doesn’t have any edge in gauging the severity of this virus or how effective the containment will be, so we don’t know the timing of any recovery beyond what a recovery “might” look like.

In times of short-term volatility, Callan and our clients need to be mindful of the long term. We followed a process to plan for capital market uncertainty and to meet our tolerance for risk. When uncertainty strikes, we need to trust the policies we put in place to enforce discipline and enact rebalancing when emotion can make it difficult.