New federal pension rules that raise the discount rate applied to liabilities for contribution purposes have opened the debate on whether plan sponsors should delay implementation of asset-liability matching long-duration strategies. The new rules, which were included in the transportation bill that President Obama signed in July, may provide relief from the impact of the currently very low interest rates used to calculate liabilities for the purposes of determining minimum contributions under ERISA. Plan sponsors may be tempted to use this relief to reduce contributions and/or shorten duration in anticipation of higher interest rates. However, we believe that plan sponsors should think carefully before doing so, as relief from the law likely will be temporary and higher interest rates don’t necessarily undermine the long-term case for owning long-duration assets.
New Funding Rules
In 2006, Congress passed the Pension Protection Act (PPA), a landmark in pension legislation which made significant changes to the way corporate plan sponsors calculate and manage the funded status of their pension plans for the purposes of meeting ERISA requirements. In early July of this year, Congress passed the Moving Ahead for Progress in the 21st Century Act (MAP), which contained permanent amendments to the PPA and, most importantly, changed the methodology for calculating liability discount rates for probably the most popular yield curve option available to plan sponsors.
In the current system, many plans opt to estimate liabilities for contribution purposes using three segment interest rates drawn from average corporate bond yield curves over the previous two years. Published by the Internal Revenue Service, each segment interest rate covers a different portion of the yield curve.
The new law establishes a floor and a ceiling for the segment interest rates, based on a percentage of rolling 25-year averages for those rates. For 2012, the floor is 90% of the 25-year average segment rate and the ceiling is 110%. The floor will gradually be lowered and the ceiling raised over the next several years before settling at 70% and 130%, respectively, after 2015. The range between the floor and the ceiling is known as the corridor.
The new funding rules apply only to those plans that have decided to use segment interest rates — instead of the entire corporate yield curve — to calculate discount rates for contribution purposes. We estimate that this new system could initially increase an eligible plan’s discount rate between 100 and 135 basis points, significantly improving plans’ ERISA funded status for contribution purposes in the short term. This could allow already well-funded plans to forego contributions and less well-funded plans to shrink contributions by 40% to 50%.
Relief Is Temporary
Plan sponsors should be cautious about changing contributions based on the new rules. First, this funded-status improvement for contribution purposes will be temporary. Once interest rates enter the corridor — meaning they are above the floor and below the ceiling — plan sponsors will resume using segment interest rates that are determined by the two-year averaging process, so the law will provide no further relief. The odds that interest rates will enter the corridor will increase each year as the ceiling is gradually raised and the floor lowered before stabilizing in 2016. Consequently, these discount rates are likely to fall within the bounds of a corridor that is steadily expanding unless rates drop off dramatically, in which case the lower bound will act as a buffer.
Second, the new rules don’t change the long-term economics of pension plans, including the impact on balance sheets under corporate accounting rules. Companies will still be using high-quality corporate bond rates as required by the Financial Accounting Standards Board (FASB) in valuing liabilities on their books. The new rules also won’t affect the accrual of benefits during the temporary period of relief, which should last only three to four years. Once the relief provided fades, reduced contributions under the new system likely will have to be made up or even increased if the plan funded status has since worsened.
Again, under the new law, any improvement in funded status for determining contributions is not the result of market movement in interest rates. Rather, it is based on modified interest rate levels created by the floor and ceiling. Therefore, plan sponsors should be cautious about making changes to their contribution levels based on this (temporary) improved funding status. While many plan sponsors may take advantage of this temporary legislative relief, forgoing contributions will not change the long-term economics of pension promises and could result in even larger contributions having to be made down the road.
Plan sponsors shouldn’t just be cautious in deciding whether to decrease contributions in response to the new rules. They should also be careful about changing investment strategies based on the new modified rate structure. They should also be aware of any implied or explicit interest rate views they might be expressing in their overall fund structure.
The new legislation does introduce a potential complication over the next few years resulting from the switch to the new formula for calculating discount rates. This relates to the long-term secular decline in interest rates, which will gradually be captured in the rolling 25-year period. As a result, segment interest rates will decline as fewer high-interest-rate years from earlier periods and more low-interest-rate years from recent periods are included in the rolling 25-year average. For at least the next few years, this means that a plan sponsor’s discount rate could decline even as current interest rates rise. A look at historical data illustrates this point. Using 10-year U.S. Treasury rates as a proxy, if this new rolling rate had been in effect, plan sponsors between 2004 and 2007 would have seen 10-year U.S. Treasury yields rise even as the discount rate declined, as shown in Figure 1. In this scenario, near-term interest rate increases would reduce the value of fixed-income portfolios at the same time as a lower discount rate increases the value of liabilities, leading to a disconnect between the changes in asset and liability values in the near term for ERISA calculations.
Figure 1: Between 2004 and 2007, the 10-Year Treasury Yield Rose and the 25-Year Moving Average Fell
The potential delinking of behavior between bond assets and pension liabilities over the next few years does raise questions regarding long-duration bond strategies that have been utilized to better match plan liabilities. During the next few years, these strategies will not offer a direct hedge against liability calculations for ERISA contribution purposes. However, they will continue to offer a hedge for FASB, or accounting, purposes for which current, long-term corporate bond yields are used to discount liabilities. In addition, the discount rates for ERISA calculations will likely converge with market rates in the next four years or so, at which point long-duration strategies will again move more closely in line with the discount rate for liabilities.
The Prospect of Rising Rates
A common refrain among many plan sponsors today is that interest rates are low and likely to move higher. While higher interest rates in the future are possible, it is important to understand the full range of potential outcomes, including the potential changes in the yield curve.
First, history has shown that the Treasury yield curve has steepened during financial crises only to flatten later. The curve steepened during the savings and loan crisis in the early 1990s and the 2001 recession and flattened afterward as the markets recovered, returning to a typical slope within the next few years. Currently, the yield curve is historically steep (Figure 2). Based on an analysis of those periods, the curve could flatten 50–100 basis points in the spread between the five-year and the 30-year bond over a one- to two-year period.
Figure 2: Yield Differential Between a 30-Year Treasury Bond and a Five-Year Treasury Note Since August 28, 1987
Given that short-term Treasury rates are now near zero, it is possible that short-term rates would increase more than long-term rates in a rising-rate scenario — meaning that a long-duration portfolio would outperform a shorter-duration portfolio, says Luke Farrell, fixed-income investment specialist for Capital Group Institutional Investment Services.
“What would be the first thing that would happen to drive interest rates higher?” he asks. “The Fed would probably stop quantitative easing and start raising the fed funds rate. So the curve would likely flatten, which means that rates at the short end would go higher more quickly than those at the long end.”
In addition, the same factors that drive interest rates higher, such as inflation, economic growth expectations and monetary policy, also tend to flatten the curve.
It isn’t clear that long-term interest rates will rise soon. Rates have remained stable after some financial crises, such as in the years 1936 to 1953, when 10-year Treasury yields hovered around 2% (Figure 3). The U.S. economy is currently recovering from a significant period of debt growth that was centered around housing. While that has stabilized, government debt levels have reached very high levels relative to GDP; it will take time to return to a more sustainable debt trajectory.
Figure 3: Interest Rates Remained Stable in the 10–15 Years After the Great Depression
One circumstance that makes the current period slightly anomalous compared to the past is the use of nontraditional monetary policy tools by the Federal Reserve. Studies have shown that the Large Scale Asset Purchase program and the Maturity Extension Program have resulted in lower long-term interest rates (a desired policy outcome), which have contributed to lower interest rates used to discount pension liabilities.
Many plan sponsors and market participants assume that the unwinding of Fed policies will entail either higher interest rates or higher inflation (or both). While such an outcome is possible, it is unlikely that the Federal Reserve would tolerate either, given its legislative mandate to promote maximum employment, stable prices and moderate long-term interest rates. A sharp rise in real interest rates would threaten employment growth; a sharp rise in inflation would not be consistent with stable prices. In either case, the Federal Reserve would take preventive action if it could.
It is important to acknowledge that it is not just Treasury yields that are important, but corporate spreads as well. Rising interest rates coming on the heels of improved economic growth would likely drive the spread of corporate bonds over Treasuries lower, at least partly offsetting the rise in Treasury yields. So, long-duration strategies have potential advantages in a scenario of rising rates due to the likely flattening of the yield curve and tighter corporate spreads.
Ultimately, the new rules shouldn’t cause a plan sponsor pursuing long duration to deviate from that strategy, Farrell says.
“The motivation for pursuing a long-duration strategy today is not any different with the new law,” he said. “The only thing that this legislation does is allow plan sponsors to lower near-term contributions. It doesn’t change a plan’s long-term economic risk profile or goals.”
Regardless of their position on long duration, some plan sponsors may be tempted to shorten duration to market-time future interest rate increases — in other words, to act on an explicit interest rate view. However, interest rate changes are difficult to predict, and formulating an investment strategy around an interest rate view can present risks to the plan sponsor.
We believe that plan sponsors considering or currently implementing a long-duration strategy should not attempt to time the market by delaying implementation of long-duration strategies, even if the new rules shield them from some of the risk of maintaining a shorter duration for a few years. Instead, assuming the strategy fits the plan’s risk profile, it makes sense to match liability duration even if higher rates are anticipated. Likewise, plan sponsors should carefully consider whether it is appropriate to alter contribution levels in response to rule changes that likely will only provide a few years of contribution relief.