Pension plans funded status has, more or less treaded water for almost ten years, despite extremely favorable investment returns. References are commonly made that infer plans are more poorly positioned than ever.
"Despite strong investment gains, health of largest U.S. corporate pension plans showed no improvement in 2020" – Towers Watson Analysis, January 2021
"Big gains did little to boost corporate pension plans" – Wall Street Journal, Jan 2021
If strictly evaluated on a Pension Benefit Obligation (PBO) funded status basis, those statements may well be indicative of U.S. corporate pension plans. However, as discount rates have declined to historically low levels, this metric of comparing the present value of the liability to the current asset values may no longer be indicative of the real economic position of the plan, or indicative of the success or failure of pension strategy.
Why has funding level improvement been so limited?
Over the past ten years, U.S. corporate pension plan funded status has remained fairly static, at approximately 80% of PBO.1 Funding measures compare the present value of the projected benefit payments by the prevailing corporate investment bond yield — the higher the discount rate, the lower the pension benefit obligation; the lower the discount rate, the higher the pension benefit obligation. As discount rates have declined precipitously, having declined from 5.54% in December of 2010, to 2.52% in December of 2020, the present value of the liabilities has increased significantly.2 Despite a remarkable ten-year period of investment returns, during which a portfolio of 60% MSCI World Equity /40% Barclay Aggregate Bond Portfolio Index/40% Bloomberg Barclays U.S. Aggregate Bond Index returned 7.8%, plans remain significantly underfunded by traditional pension metrics.3
However, this hardly represents the relative financial position of the pension plan, or the progress that has been made during this period. SEI’s analysis indicates that, contrary to conventional measures, most pension plans have significantly improved their economic position relative to their liabilities. To understand why that is, we first need to evaluate the common corporate pension strategy. While many plans, especially those that are very large or very well-funded, aggressively hedge their liabilities, many do not. The majority of pension plans invest in a balanced portfolio of equities, fixed income and other asset classes, in an effort to seek higher market returns. This strategy targets two goals:
- Improving the PBO funded status over time
- Utilizing a combination of market returns, time and inflation, to reduce the cost of benefits
This strategy has largely been unsuccessful in goal number 1, as plans have not been able to improve their funded position, almost entirely due to the significant decline in discount rates. However, most plans have been very successful in goal number 2. An in-depth analysis of 20 pension plans from 2015 to 2020 indicates that every plan had improved considerably if measured by pension assets as a percentage of total benefits due to pensioners. Median asset values increased 9% over this time period, while the economic liability (total benefit payments owed beneficiaries) declined 17%. In every plan analyzed, the economic position of the plan improved, with median levels rising from 39% of economic liability to 54%.4 Simply put, plan assets have, by and large, grown thanks to solid investment returns, while total liabilities have declined as benefit payments are made. By any reasonable measure of financial progress, most U.S. corporate pension plans have enjoyed significant success in what should be their primary goal.
An illustration of this progress, despite lack of PBO funding improvement, is below. This closed and frozen corporate plan was 74% funded as of December 31, 2018, and remained 74% funded as measured on December 31, 2020. However due to strong market returns, and the payment of considerable liabilities over that period, the plan was in a considerably improved financial position. Applying a 6.5% investment to starting asset values at each point in time, and subtracting projected benefit payments, expenses, and Pension Benefit Guarantee Corporation (PBGC) premiums, we can project a path of asset values through time. Starting at the 2018 value the plan would run out of funds in approximately 18 years, while the plan starting at 2020, with somewhat lower projected pension payments, would fully fund its liability. Despite being in a similar actuarial position, the plan’s strong investment returns over 2019 and 2020 had placed it on much more favorable financial footing.
Why is this fairly reasonable approach to pension measurement not commonly reflected in discussions regarding investment strategy and pension performance? A consistent mark-to-market mentality potentially distorts the reality of the obligation. Focusing on the present value of the obligation rather than the current assets in hand places unreasonable focus on payments far out in the future as current problems, and implies this “gap” is a real financial liability. This is only true if the plan sponsor seeks to settle that liability now or in the near future, or if the company is going to be shuttered or sold. Otherwise, assuming the long standing return oriented strategy remains intact, the actual financial obligation may not only be considerably smaller, but may be zero, depending on long term investment returns.
The constant measurement of pension payments 10 and 20 years out also creates an unreasonable focus on the pension relative to other future expenses. Based on my 35 years of experience within corporations, and as an advisor, few companies have robust three-year plans, and rarely five-year plans. Few consider meeting expenditures out over that planning horizon. In contrast, far distant pension expenditures are actively measured in current liability terms, despite the fact that, relative to almost all other future expenditures, pension payments are often well-funded, manageable within the framework of the corporate cash flows and modest relative to other expenditures. It is only in the present valuing of those liabilities, applying extremely low discounting rates, that those liabilities become large, underfunded and immediate. In doing so, plan sponsors are in effect mentally unwinding the benefits of their pension investment strategy.
It’s a legacy liability
Another consideration beyond mark-to-market measures that adds to plan sponsors consideration of pension expenses as something different than other expenses is a view that it is a “legacy” liability. The pension is viewed as a “cost” of the firm, the benefits of which were gained years ago, and the value of which has long passed. The pension is thus considered an ongoing financial drag without benefits that needs to be addressed sooner rather than later. But is this an accurate assessment? Assuming the pensions were a component of a competitive compensation scheme, those benefits may well still be present in the form of retained customers, product innovation or opened distribution markets that continue today. Even if that is not the case, there is no reason to treat those expenses as more problematic than other current expenditures; indeed financially, the opposite is more likely true. If one considers current expenses as “prepaid” expenses, given that the benefits of today’s actions are likely to be gained by the firm in the future, paying up front hardly seems the preferable approach from a cash flow perspective, relative to deferring those payments. If all expenses could be paid in the future like pension payments (simply differed compensation), from a cash flow perspective, the firm would likely be better off. It would be unreasonable to later complain about those deferred payouts that improved corporate cash flows when the bill arrives 20 years hence.
Taking a broader perspective
Clearly, the above analysis indicates PBO funding measures are not the only way to evaluate pension plans. In an era of ultra-low discount rates, they may not even be the best measures. For plans with extremely large relative liabilities, plans seeking to annuitize in the near term or firms seeking to sell, current mark-to-market measures are valuable considerations. For plans with longer time horizons continuing to use market returns and time to meet liabilities with a return-oriented portfolio has proven successful, and there is little reason to believe will not continue to be so, regardless of funding measures. Rather than focus on PBO funding, plan sponsors may want to focus more closely on FTAP/ERISA funding measures, currently utilizing significantly higher discount rates that drive required contributions. That measure can have a much more significant economic impact on plan sponsors, and help determine the ability to continue to take market risk through time. Funding relief, like that in place the last ten years and currently being contemplated in new legislation, provides a greater runway for plan strategies to play out. The most important issue is the plan sponsor’s ability to manage investment risk, and be in position to fill prospective contribution requirements resulting from asset-liability volatility. Pension plan sponsors embarked on this path decades ago, and it has generally worked. A long-run focus and patience likely continue to be the best approach for most pension plan sponsors.
1S&P CapIQ December 31 2019 and SEI analysis estimates through December 31, 2020
2FTSE Pension Discount Curve December 31, 2020
3Factset 10 years ending 12/31/2020
Information provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company (SEI).
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