The 5 Myths: Myth No. 2, Delayed Implementation
The 5 Myths Holding Back Plan Sponsors
Myth TwoThe Impacts of Financial Markets
- Myth Companies are better off delaying the implementation of DB risk management solutions to benefit from further improvements in the financial markets.
- Fact There is no major benefit to increasing funded status compared to the potential risks associated with market volatility.
In a recent survey of U.S. corporate pension executives, just 16 percent of plan sponsors indicated that volatility is their top concern regarding their investment portfolio.1
Equity markets and interest rates are unpredictable, making relying on continued improvements in market conditions to close funding gaps a risky venture.
These sponsors may be misjudging the risk they are taking, because specific market conditions must exist for plans to experience further funded status improvement. An interest rate increase for long-duration, investment-grade corporate bonds would benefit plan sponsors more than an increase for shorter-duration bonds. This is because DB plans must discount future liabilities based on the prevailing rates on investment-grade corporate bonds that match the duration of their plans’ liabilities. Moreover, a rise in interest rates for these bonds would not benefit the typical plan sponsor if it were accompanied by an equity market decline.
Over the four-month period of April to July 2013, equity markets rallied;2 however, because of the surge in interest rates, the market value of pension assets declined.3 Liabilities also declined, contributing to an 8.5 percent improvement in funded status. However, relying on continuing improvements in market conditions to close funding gaps is a risky venture, because equity markets and interest rates can be volatile and are unpredictable.
As the following chart illustrates, an opposite phenomenon occurred in 2011 when, in a four- month span, liabilities increased 13.1 percent while market value of assets fell 5.3 percent, eroding 14.2 percent in funded status.4
Volatility Caused by Asset & Liability Mismatch
|Funded Status %||81.2% in April 2013||86.0% in May 2013||88.2% in June 2013||89.7% in July 2013|
- Market Value of assets: -0.5%
- Projected benefit obligations: -10.0%
- Funded status: +8.5%
|Funded Status %||87.0% in June 2011||83% in July 2011||79.3% in August 2011||72.8% in September 2011|
- Market Value of assets: -0.5%
- Projected benefit obligations: +13.1%
- Funded status: -14.2%
Source: Milliman Pension Funding Index, October 2011 and Milliman Pension Funding Index, July 2013. The percentage of pension fund assets allocated to equities, fixed income and other investments in the Milliman 100 Companies was 38%, 41% and 21% respectively at the end of 2012 and 2011, Milliman 2013 Pension Funding Study.
Not Worth the Risk
The risk of relying on improved market conditions to further enhance funded status can be evaluated by measuring how likely a plan’s funded status is to improve over time solely through changes in the financial markets. Using the hypothetical DB plan introduced earlier in this paper, Prudential conducted 1,000 Monte Carlo simulations of how this plan’s funded status would change over 10 years, assuming no incremental contributions are made to the plan (yet benefit payments are made from plan assets).
Financial market conditions, including interest rates and equity markets performance, vary in each simulation. The results of this analysis are provided in Exhibit 1.
As shown in Exhibit 1, there is an approximately 48 percent probability that the plan’s funded status will deteriorate at the end of 10 years. Moreover, there is an approximately 30 percent probability that the plan’s funded status will deteriorate by 25 percent or more. For a well-funded plan, these findings illustrate the significant risk of funded status deterioration from current levels.
Exhibit 1: Range of Funded Status Outcomes in 10 Years without Incremental Plan Contributions
|Probability of increase or decrease in funded status from current 95%||3.6%||12.6%||29.9%||41.3%||47.8%||52.2%||45.4%||36.2% (no economic benefit)||22.5% (no economic benefit)||12.6% (no economic benefit)|
|Amount of increase or decrease||-75%||-50%||-25%||-10%||Less than 0%||Greater than 0%||+10%||+25%||+50%||+75%|
|Funded Status||Less than 24%||Less than 48%||Less than 71%||Less than 86%||Less than 95%||More than 95%||More than 105%||More than 119%||More than 143%||More than 166%|
- Plan asset allocation at the beginning of the 10 years is 65% equities, 30% fixed income, and 5% cash.
- Plan assets are rebalanced annually to match the starting asset allocation of the plan.
- No incremental plan contributions are made during the 10 years.
- Analysis based on 1,000 Monte Carlo simulations for the DB plan over 10 years. Barrie and Hibbert Economic Scenario Generator assumptions used in Monte Carlo analysis.
Of course, some plan sponsors may still be willing to take the chance that future market conditions may (or may not) improve funded status. Sponsors of well-funded plans (average funding was 81.8% at December 31, 20155) are poorly compensated for bearing this risk, however. Once a plan’s desired funding level is reached—such as 105 percent to 110 percent of plan liabilities, particularly for frozen plans—the plan sponsor receives little economic benefit from a further improvement in funded status, as excess funds in the plan cannot be used for other business purposes. Therefore, as a plan approaches fully funded status, the plan sponsor’s upside is capped, as represented by the three bars on the right in Exhibit 1, while its downside is not.
Once a plan’s desired fund level is reached the plan sponsor receive little economic benefit from further improvement in funded status.
In certain circumstances, delaying the implementation of risk management strategies while, for example, waiting for interest rates to rise will have no discernible impact. For plans with already meaningful positions in fixed income that “well match” the retiree portion of their liability, there may actually be advantages to transferring risk now.
Since these plans are partially immunized against interest rate movements for a given portion of their liability, risk of funded status deterioration due to adverse movements in rates may not be a significant issue. However, the plan continues to own the longevity risk, as well as the cost of plan administration and PBGC premiums. Legislative changes since 2013 have resulted in significant increases in the flat-rate and variable-rate premiums charged by the PBGC, making them now an even larger component of overall plan costs.6 The increased burden will be greater for plans that are currently in deficit than for plans that are fully funded, at least until the deficit is closed.
There is ample capacity for transferring risk to insurers. And although capacity is likely to be available in the future through traditional and/or new sources, the cost may rise as the supply-demand dynamic for long-dated corporate bonds changes. Furthermore, the business mix of insurers may shift as their own exposure to longevity risk increases, causing capital to become less abundant.