KNOWLEDGE CENTER

Knowledge Center Archive

Oct
22
2010

How DB Plans Should React to Changing News on the Outlook for Funding Levels

Changing Headlines: "It's Good...It's Bad...It's the Same."

It has been a wild ride for corporate defined-benefit plans in recent months as funded status levels have spiked and plummeted, often without warning. Headlines at the end of August highlighted that the funded status of U.S. pension plans (on an accounting basis) neared an all-time low, suggesting a funded levels decrease by four percent in just one month. Then in September, following a strong capital markets rally, headlines boasted that funded levels made the greatest one-month improvement of 2010, gaining 4.6 percent. The latest industry reports suggest that the funded status of pensions dropped an overall one percent during the third quarter[1]. Unfortunately, it seems that one of the few constants over the past several years has been the month-to-month volatility in funded status; however, pension plan sponsors should consider three key factors before hitting panic button:

1. Volatility on Accounting Side Does Not Reflect Impact on Cash Requirements

The majority of industry reports focusing on funded status volatility are determined by using an accounting set of numbers, which are required to recognize full surplus or deficit on the corporate balance sheet. This surplus or deficit equals the market value of assets less the market value of liabilities (using current discounting rates), without any averaging or smoothing. As a result, large movements in asset values AND interest rates are each contributing to the pension funded status results.

For many plan sponsors, the bigger concern regarding the pension plan is the impact this volatility will have on cash contributions. Cash payments to the pension are based on ERISA and PPA requirements (not on accounting rules) that permit liability interest rates and asset values to each be determined with up to 24 months of smoothing. The ability to smooth the liabilities, as well as the assets, removes the peaks and valleys that are ultimately causing media headlines. However, while we may expect the cash funding results to follow the accounting results, they will be delayed, muted and may be erased by more recent experience.

It’s important to remember that some plans may not use smoothing at all in their cash determinations. These plans are typically in a process of significant interest-rate hedging so the headline issues do not apply. See item 3 below for a further discussion of this issue.

2. Interest Rates can be Friends or Foes, But You Don’t Know Which Until Later

During the past two years, a significant contributing factor to the overall volatility in the funded status has been the month-to-month volatility in interest rates. The most important measure for Calendar Year Fiscal filers is the December 31 liability index (e.g., the Citigroup Pension Liability Yield Curve). This set of index rates will determine the Balance Sheet amount of surplus or deficit as well as the 2011 pension expense. It is important to remember that history has shown the rate, and therefore the liability, can change dramatically during the fourth quarter, or in a single month.

As an example, let’s look at what happened during the final two months of 2008. At the close of October 2008, as plan sponsors were determining their year-end results, the extent of the impact of the capital market decline was becoming clearer. One area of solace was that as of October 31, effective discount rates were above the prior year-end by more than 150 basis points (bps) – from 6.37 percent to 8.30 percent using the SEI Pension Liability Index or SPLI [2] – signifying a large reduction in liabilities for plan sponsors. This reduction would have mitigated the blow of the asset losses. As a result, plan sponsors may have budgeted for year-end 2008 and for fiscal 2009 under the assumption that the index would finish above, or at the very least, even.

However, as November and December progressed, we saw Treasury and corporate rates fall precipitously. Unfortunately for plan sponsors, the SPLI plummeted during these final two months of 2008 by 215 bps, – 83 bps in November and 132 bps in December. This was the largest one-month swing in this index ever. Up until that point the index had only seen one swing of this magnitude (more than 75 bps) - and here were two in a row.

Remember that headlines may grab one’s attention, but it’s important to consider the current situation. Keep in mind that while current rates are at recent record lows (in October 2008, they were at 10-year highs), there are still three months of results to be produced on the asset and the liability sides, and year-end may be better or worse than it was on September 30, 2010.

3. Funded Status Needs to Be Viewed on an Individual-Plan Basis

There are a number of reasons to view the reports of increases and decreases of funded status with a grain of salt. In addition to the two key reasons above, it is equally important to recognize that most industry reports are based on the results of a subset of pension plan sponsors. Most of the time, a composite (e.g. the S&P 500) is used as a benchmark and the specifics of those plans can be very different from what other plan sponsors are experiencing.

Pensions should be managed on a case-by-case basis and according to the individual goals of the organization and the plan. Numerous factors that should be considered include: whether or not a Liability-Driven Investing (LDI) strategy is implemented, the historical contribution policy, and the specific benefit payout timing. All of these can impact the funded status. It’s also import to consider that asset allocations vary from plan to plan and therefore, so do market returns. Not all pension plans invest in alternatives, and of those that do, their total allocation in alternatives varies quite drastically from plan to plan. If a report includes a large portion of plan sponsors with any sort of similarity (e.g. very large plans, plans that have not implemented LDI strategies, plans with older populations, etc.), the reader should consider that the funded status of the majority of these plans may vary significantly from their own plans.

As a whole, most industry reports are based on the experience of plans that a large portion of other plans cannot necessarily relate to on an ongoing basis. Before reacting, pension plan sponsors should take into account how their plan and organization compares to those used in any report. 

[1] “U.S. Pension Fund Fitness Tracker” UBS Global Asset Management, October 2010

[2]SEI Pension Liability Index is created by applying Citigroup Pension Liability Discount Curve spot rates to a benefit payment stream reflecting a mature defined benefit plan.

For more information please email seiresearch@seic.com. This information is for educational purposes only. Not intended to be investment, legal and/or tax advice. Please consult your financial/tax advisor for more information. Information provided by SEI Investments Management Corp., a wholly owned subsidiary of SEI Investments Company. ©SEI 2010