It may be that we are starting to notice dusk arriving earlier in Central New York or that we are just hoping to wrap up 2020 and start anew, but here at BPAS, we have an eye on 2021 budgeting for our clients. It seems early to be discussing this, you may say, with nearly 4 months left in the year and an election but, as the old adage goes, people don’t plan to fail, they fail to plan. Like Fall, the future will soon be upon us, so let’s all look ahead.
The drop in interest rates that we saw occurring in 2019, where corporate bond rates dropped nearly 100 basis points, has continued into 2020 in a similar fashion. Based on the FTSE Pension Liability Index, rates were down another nearly 90 basis points by the end of July. This drop has significant ramifications for pension plan sponsors, as both their accounting liabilities and funding liabilities are tied to the level of corporate bond rates in some fashion. As interest rates decline, pension liabilities increase because there is less discounting of expected future cash flows. Without significant movement in rates, pension plan costs will be rising in 2021.
The drop in rates we have seen has been influenced by the policies of the Fed which has dropped rates on government securities to nearly 0%. This trend has led to a fall in government rates of all maturities and rippled across the fixed income sector. In addition, the U.S. has increased its deficit by trillions in a response to the events of 2020. As a result, these low rates may be here to stay.
In light of the discussion on interest rates above, pension trusts will likely be looking at lower fixed income returns in the future. Unless the drop in fixed income is combined with higher expected equity returns, the future return on plan assets will likely be muted compared with historical expectations. It may be an important item to discuss with investment managers, auditors, and the plan’s actuary.
Although equity markets saw a significant downturn in March of this year, both the S&P 500 and Nasdaq hit all time highs on August 24. That being said, we know that certain sectors of the economy have been impacted more severely by the events of 2020 with significant growth in some and significant contraction in others. As fiduciaries, it is wise to periodically review the plan’s asset allocation and performance, but whether scheduled or not, now may be the time to look again. As you review, consider the following questions.
- What are the future expectations of return and risk on each asset class?
- Have the plan’s or plan sponsor’s risk tolerances changed?
- Is rebalancing appropriate?
- Should we adjust our asset allocation?
- If and when is it appropriate to lock in gains?
- How best can we preserve our plan’s funded status?
Defined benefit plan costs are likely to rise over the next several years due to the decline in interest rates, the phasing out of current interest-rate relief, and the possibility of muted asset returns. Plan sponsors who are able to strategically contribute in excess off the plan’s minimum required contribution will likely put themselves in a better position. Doing so for underfunded plans will reduce the premiums paid to the Pension Benefit Guaranty Corporation (PBGC), where the sponsor will pay 4.5% (in 2020 but increased for inflation) for every dollar of underfunding. In an interest rate environment where it is difficult to get returns above 3%, this additional contribution may be a savvy move. In addition, once contributed, those assets will begin to compound at some rate of return which will further reduce future employer costs.
Each plan and plan sponsor are unique and addressing what can be done to mitigate future impacts will depend on the individual circumstances. BPAS is here to help discuss your options and address expectations so that you can plan for a more certain future.
William Stuart is Vice President, Chief Pension Actuary with BPAS Actuarial & Pension Services.