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Changing outlooks: "It's good...it's bad...it's the same"
It has been a wild ride for corporate defined benefit pension plans in 2010 as funded status levels have spiked and plummeted, often without warning. Headlines at the end of August 2010 highlighted that the funded status of U.S. pension plans (on an accounting basis) neared an all-time low, suggesting that funded levels decrease by 4 percent in just one month.
Then in September 2010, following a strong capital markets rally, headlines boasted that funded levels made their greatest one-month improvement of 2010, gaining 4.6 percent. Next, industry reports suggested that the funded status of pensions dropped an overall 1 percent during the third quarter of 2010.
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, defined benefit plan sponsors should consider three key factors before hitting the panic button:
The majority of industry reports focusing on funded status volatility are determined by using accounting numbers that are required to recognize the 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 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 not on accounting rules but on requirements under the Employee Retirement Income Security Act (ERISA) and the Pension Protection Act (PPA) that permit liability interest rates and asset values to 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 ultimately are causing media headlines. While cash funding results might follow the accounting results, they will be delayed and muted and might 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.
In recent years, a significant contributing factor to the overall volatility in the funded status of pension plans has been the month-to-month volatility in interest rates. The most important measure for calendar-year fiscal filers is the Dec. 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 upcoming year's pension expense. It is important to remember that history has shown that the rate, and therefore the liability, can change dramatically during the fourth quarter of the year or even in a single month during the final quarter.
Consider 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 Oct. 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 (SPLI)—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 might 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 2008 progressed, Treasury and corporate rates fell 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 shown only one swing of this magnitude (more than 75 bps)—and here were two in a row.
Headlines might grab one’s attention, but it’s important to consider the situation. Keep in mind that while rates at the end of the third quarter of 2010 fell to recent record lows, in October 2008 they were at 10-year highs.
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 should be considered, including 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.
In addition, it’s 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.), plan sponsors should consider that the funded status of the majority of these plans might vary significantly from their 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 a continuing basis. Before reacting, pension plan sponsors should take into account how their plan and organization compares to those used in any report.
(Note: The SEI Pension Liability Index applies Citigroup Pension Liability Discount Curve spot rates to a benefit payment stream reflecting a mature defined benefit plan.)
Jonathan Waite, FSA, EA, is director for investment management advice and the lead actuary for SEI’s Institutional Group, which delivers ongoing advice regarding investment strategy, asset allocation, funding policy and plan design. His responsibilities focus on providing advice regarding asset allocation considerations, retirement benefit plan design, actuarial methods and assumptions, and funding policies for SEI’s corporate and multiemployer defined benefit relationships. He is widely recognized by the industry as an expert in the strategic elements of pension management.
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 Co.
© SEI 2010.Reposted with permission.
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