Many retirement plan sponsors and administrators are cheering the phase-in of reduced funding requirements that tie future company contributions to a 25-year average interest rate. Nonetheless, some experts predict that the changes may encourage investors in these plans to think less about hedging risk.
A report Towers Watson issued, “The Implications of Funding Relief: What Does it Mean for Asset Allocation and Liability-driven Investing?” says new legislation— known as the Moving Ahead for Progress in the 21st Century Act — may have a secondary impact on pension fund investing beyond freeing up cash and increasing tax revenue by limiting deductible contributions. While MAP-21 meets the goal of lowering pension funding in a low-interest-rate environment, the report forecasts that the law also may set a precedent of shifting asset allocation toward building fund income and away from holding liability-hedging assets, such as bonds. This could expose corporate pension plans’ assets to greater volatility as past underfunding concerns subside.
Moving Away from Current Bond Yields
Liability-driven investing became popular after the Pension Protection Act of 2006 was enacted. PPA emphasizes valuing liabilities at current bond yields, but MAP-21’s funding relief, which allows discounting based on the 25-year average of rates that historically were much higher than they are now, accomplishes the opposite.
Specifically, the Towers Watson report says the decline of a retirement plan’s long-bond portfolio due to rising yields will no longer be offset by a decline in the value of a plan’s liabilities as measured for compliance with funding minimums.
“There will be less incentive for interest-rate matching in the near term than we have seen in the past, and therefore less incentive for corporate pension plans to hold large allocations to fixed income,” the report says. In the new world MAP-21 funding relief changes brought about, each dollar of risk invested is more heavily rewarded in terms of reduced expected contributions under the new rules than under the regime followed since PPA enactment. In the report, Towers Watson anticipates that the disconnect between the movement of discount rates and interest rates will continue for “the next few years.” That means MAP-21’s impact will extend beyond just the short-term relief originally intended while U.S. interest rates remain historically low.
Importance of Risk Reduction?
The study also cites relief measures the federal government undertook to address the severe economic conditions that arose after PPA was enacted as another reason that risk and large fixed-income default positions may matter less now for pension plan investors. “The new law … brings into question the importance of risk reduction in a system where relief laws frequently bail us out in hard times,” the study concludes.
In addition, the study echoes the prediction that the relief for corporate pension plans resulting from MAP-21’s eased funding requirements will be fairly short-lived. “Over the (next) 10-year period, … MAP-21 merely pushes contributions from period to period but does not reduce the long-term obligations of the plan.”
Finding out More
For more information about funding balances, adjusted funding target attainment percentage and underfunded retirement plans, see ¶132 in the Pension Plan Fix-It Handbook.