The passage last year of the Moving Ahead for Progress in the 21st Century Act was in part aimed at helping corporate pension plans meet their funding requirements.
To a point, it has, but the legislation may not have done much to slow the demise of traditional pension plans.
MAP-21 was actually a highway bill that contained a little-publicized provision that allows companies to set their pension plan contributions using a rate based on high-quality bond yields averaged over 25 years. Before MAP-21, the rule was two years using current rates.
Employers have to put in more money into their pension plans when rates are low and, conversely, put in less when rates are higher. The 25-year average is expected to be at least 2-3 percentage points higher than rates today.
The change was a godsend to companies experiencing cash flow issues, allowing them to redirect cash otherwise destined for higher pension fund contributions to fund other, more immediate needs. As a result, many companies responded to the MAP-21 rule by lowering their pension contributions for 2012, some by double-digit percentages.
Others, however, kept their plan funding at pre-MAP-21 levels or perhaps even increased it. And they may be the wisest of the lot, because MAP-21 may have provided the wrong route — at least for some.
In its latest corporate pensions outlook report, Fitch Ratings said that, although it “believes near-term prospects signal potential funding improvements, companies contributing the minimum under recent funding relief (MAP-21) may face a day of reckoning in the coming years due to the potential for a steep acceleration of funding requirements.”
Fitch reviewed 224 non-financial U.S.-based companies with DB plans having U.S. projected benefit obligations of $100 million or more. Of those, 148 were less than 80 percent funded.
The ratings agency said that “for a company on the edge of a rating category, weak earnings and the need to make ongoing pension contributions could lead to a negative rating action.”
According to the UBS Global Asset Management US Pension Fund Fitness Tracker, the funded status of corporate pension plans was up by a considerable margin in the second quarter of 2013, helped along by strong market performance and an increase in interest rates. But neither factor was enough, and many plans remain sorely underfunded.
Fitch has already said that problems could arise down the road that would make it wiser for companies to keep the contributions coming.
In other words, if market returns aren’t strong enough, companies that don’t make adequate contributions to their plans could be in for some uneasy times. And, of course, there’s been no shortage of speculation about when the current bear market might end.
The other big factor in all this is, again, the discount rate, which is still low — thanks to continued low interest rates. Low interest rates mean a low discount rate, which increases funding level requirements. Rates are expected to rise as the economy continues to improve, but there’s no guarantee of what might happen.
So, what can be done to help the situation?
According to Charlie Service, global co-head of retirement and advisory solutions at UBS, the best answer is “derisking” – though it’s best to view how well this strategy might work over the longer term.
Companies that derisk do so by changing the mix of their plan investments in favor of LDI, or liability-driven investments.
Ironically, “the nature of the market movements in the first 6-8 months of the year have benefited those plans that have not adopted a liability-driven investment strategy,” Service said.
“What’s happened,” he said, “is that equity markets went up and interest rates went down, and plans that have adopted these derisking protocols have been selling their equities in favor of more fixed income.
“That’s a good thing, from a long-term perspective for derisking a pension program, but in the short term they’ve been selling equities that have continued to rise. Looking at the results in the first part of year, old-fashioned programs that have not adopted derisking have actually done a little better short-term than those that have adopted a derisking program. It’s an interesting … short-term phenomenon.”
That doesn’t mean, he noted, that LDI is the wrong way to go. “On the contrary, we feel it’s the appropriate way to manage programs over the long term,” he said.
Robert Pozen, nonresident senior fellow of economic studies at the Brookings Institution, noted that while many corporate pension plans are derisking, many public plans “that are essentially unfunded or underfunded have gone into alternative investments heavily.”
Eric Keener, partner and chief actuary at Aon Hewitt, said diversifying into alternative investments may work for some plan sponsors but many of his company’s clients are moving instead into derisking. Removing the risk from equities in favor of the stability of fixed-income investments may mean that companies will need to contribute at a higher rate, but it also reduces the volatility of contributions.
“The more you allocate toward return-seeking assets, the greater the chance the market will move against you, and you’ll need to put more money into the plan. In a down market, it may be harder for you to do that.”
There’s another measure a company can take: contributing its own preferred stock as a way of increasing the size of its plan contribution.
AT&T, for example, did this.
“It believed preferred stock would provide a better return to the pension fund, and it wanted to close its funding gap,” Keener said.
And, of course, companies wanting to end their pension headaches once and for all are “pursuing lump sum windows,” Keener said, offering either the vested population or the entire plan population a lump sum rather than an annuity. “General Motors did that and so did Verizon,” he noted. Ford has, too.
Less radically, Service said plan sponsors can also look at changes to funding ratios.
That’s most commonly done by freezing benefits, he said. Pensioners hate that, so it’s a move with “repercussions,” he said. Still, “a lot of programs have been frozen or closed in the past decade, so it’s more common now to find frozen and closed programs than was the case before the Pension Protection Act of 2006 came into force.” Goodyear Tire and Rubber is about to become the latest company to do so.
Pozen warned last year against companies relying too heavily on MAP-21 to solve their pension funding problems, saying that the 25-year averaging period went “too far,” and that somewhere in the neighborhood of five to 10 years would be more realistic.
Earlier this year, Milliman warned that, should interest rates remain low, keeping discount rates low, the only options open to companies would be strong market returns or larger contributions. In other words, companies that have availed themselves of MAP-21 to reduce plan contributions may have bought themselves some time but aren’t really better off than before.
The retirement system is in crisis but if there’s any good news in this, it might be that the number of workers with pensions has been on a steep decline for decades now. According to the Bureau of Labor Statistics, about 18 percent of full-time private industry employees had a defined pension benefit in 2011 vs. down from 35 percent in 1990.