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

After a slow start in January, major equity indices enjoyed steady gains through the end of April. However the struggles of May and June have left those benchmarks down as much as 15% from their April highs by the year's calendar midpoint (although the six-month period ending June 30, 2010 still produced equity losses of "only" 6%-8%).

Investment performance, however, only accounts for half of the proverbial pension balance sheet equation. On the liability side, corporate bond yields continue to struggle. In fact, despite some "noise" along the way, the Citigroup Pension Index has seen steady declines in its published benchmark totaling nearly 200 basis points (bps) since the first quarter of 2009, including a 70bp reduction during the past three months.

Citigroup Pension Index Comparison of Discount Rates

 

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. Projecting these segment rates by assuming no change in the yield curve during the next several months results in less-than-desirable outcome for calendar year plan sponsors.

 

  2010 Plan Year (Actual) 2011 Plan Year (Projected)
First segment rate 5.03% 3.81%
Second segment rate 6.73% 6.34%
Third segment rate 6.82% 6.59

 

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). Even prospects for a rate rebound won't likely provide substantial relief because as many as 21 of the 24 months used in the average have already passed. By way of comparison, if spot rates increase 10 bps (0.1%) each of the next three months, the resulting segment rates would be 3.83%, 6.36%, and 6.61% - a negligible change.

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.

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, plan sponsors may benefit from applying funding relief to the 2009 and 2011 plan years rather than 2009 and 2010 plan years. In addition, the magnitude of the potential savings and cash flow implications under each alternative must be analyzed.

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 six months, plan sponsors using a 1/1 - 12/31 fiscal year may find it difficult to justify the use of a year-end discount rate as high as that used for prior fiscal year disclosures. The graph below compares duration-specific Citigroup Pension Liability Index yields from December 2009 with the most recent rate information for June 2010.

Citigroup Pension Index Comparison of Discount Rates

While corporate bond yields may fluctuate significantly during the second half of 2010, Citigroup's published yield has fallen 51bps since December 2009. This downward trend appears to have continued since the beginning of July. Using the US Treasury curve as a proxy, bond yields have continued to fall throughout the month, albeit on a much less pronounced basis than during June (during which the published Citigroup rate fell by nearly 40 bps). Absent a reversal of this trend, defined benefit plan sponsors could face year-end accounting liability increases of 5% to 8% - an increase that directly impacts Accumulated Other Comprehensive Income (AOCI) as a negative adjustment to equity at a time when unfavorable investment performance could have a similar effect.

Individual spot rates during the past six months have fallen for nearly every discount period within the Citigroup Pension Index. The change is most dramatic during years 5-20 where the average decrease is more than 70bps. Frozen plans and plans with higher average participant ages may face larger fiscal year-end rate reductions as the expected benefit payment structure of these plans typically results in liability patterns that are more affected by changes to years 5-20 of the yield curve.

Next Steps

We continue to encourage additional liability-duration and yield analysis to better understand the specific impact all of these changes might have on your plan. When combined with forward-looking projections of funding costs and fiscal year-end financial positions, plan sponsors will be able to avoid contribution and balance sheet surprises and better prepare updated fiscal 2011 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 GAAP. We'd be more than happy to share our LDI presentation with you and discuss what's available in the marketplace to help better manage plan volatility.

Please do no hesitate to contact us with any questions.


The information being provided is for general education purposes and with the understanding that it not intended to be used or interpreted as specific legal, tax or investment advice. The scenarios do not address or account for individual investor circumstances. Investment decisions should always be made based on your specific financial needs and objectives, goals, time horizon and risk tolerance. Summit Financial Corporation and its representatives do not provide tax or legal advice to individuals. Consult your tax advisor or attorney regarding specific tax issues.

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.