Skip to main content
MENU
Subscribe
  • Sign Up Free
  • LOGIN
  • Subscribe
  • Topics
    • Alternatives
    • Consultants
    • Coronavirus
    • Courts
    • Defined Contribution
    • ESG
    • ETFs
    • Face to Face
    • Hedge Funds
    • Industry Voices
    • Investing
    • Money Management
    • Opinion
    • Partner Content
    • Pension Funds
    • Private Equity
    • Real Estate
    • Russia-Ukraine War
    • SECURE 2.0
    • Special Reports
    • White Papers
  • Rankings & Awards
    • 1,000 Largest Retirement Plans
    • Top-Performing Managers
    • Largest Money Managers
    • DC Money Managers
    • DC Record Keepers
    • Largest Hedge Fund Managers
    • World's Largest Retirement Funds
    • Best Places to Work in Money Management
    • Excellence & Innovation Awards
    • WPS Innovation Awards
    • Eddy Awards
  • ETFs
    • Latest ETF News
    • Fund Screener
    • Education Center
    • Equities
    • Fixed Income
    • Commodities
    • Actively Managed
    • Alternatives
    • ESG Rated
  • ESG
    • Latest ESG News
    • The Institutional Investor’s Guide to ESG Investing
    • ESG Sustainability - Gaining Momentum
    • Climate Change: The Inescapable Opportunity
    • Impact Investing
    • 2022 ESG Investing Conference
    • ESG Rated ETFs
  • Defined Contribution
    • Latest DC News
    • DC Money Manager Rankings
    • DC Record Keeper Rankings
    • Innovations in DC
    • Trends in DC: Focus on Retirement Income
    • 2022 Defined Contribution East Conference
    • 2022 DC Investment Lineup Conference
  • Searches & Hires
    • Latest Searches & Hires News
    • Searches & Hires Database
    • RFPs
  • Performance Data
    • P&I Research Center
    • Earnings Tracker
    • Endowment Returns Tracker
    • Corporate Pension Contribution Tracker
    • Pension Fund Returns Tracker
    • Pension Risk Transfer Database
    • Future of Investments Research Series
    • Charts & Infographics
    • Polls
  • Careers
  • Events
    • View All Conferences
    • View All Webinars
    • 2023 Defined Contribution East
    • 2023 ESG Investing
Breadcrumb
  1. Home
  2. INDUSTRY VOICES
June 03, 2019 01:00 AM

Commentary: The end of interest rate relief is coming

Joe Anzalone and Michael Clark
  • Tweet
  • Share
  • Share
  • Email
  • More
    Reprints Print
    Joe Anzalone and Michael Clark

    Joe Anzalone and Michael Clark

    Low interest rates and the sunsetting of favorable funding rules will create significant increases in contribution requirements in the next few years. Congressional action early this decade protected plan sponsors from feeling the full effect of the current low-interest-rate environment, but that protection is set to phase out starting in 2021. It is critical that defined benefit sponsors understand future expected cash contributions so they can make plans now and avoid unpleasant surprises later.

    Single-employer private-sector pension plans are required to determine minimum funding liabilities using yields on high-quality (A or better) corporate bonds. These rates are published by the IRS in a few different forms, but most plan sponsors use the three-segment yield-curve option that averages these corporate bond yields over a two-year time horizon.

    The market collapse in 2008, combined with the plummeting of corporate bond yields starting in 2011, created significant contribution pressure for plan sponsors. Congress reacted by enacting a number of funding relief measures. One of these measures was so-called "interest rate stabilization." Sponsors using the two-year average yield curve would now additionally reflect the average of the last 25 years of corporate bond yields when valuing their minimum funding liabilities.

    The practical implication of the relief was to limit interest rates to be close to their 25-year averages initially, with this limitation set to phase out over a few years. The first year the law was in effect — 2012 — a 10% corridor around the long-term average was used and was set to widen by 5% each year thereafter until it reached 30% in 2016. However, Congress extended the initial 10% corridor twice — first to 2017 and then again to 2020. The impact of this action has been "temporary" relief that has lasted seven years already and will only begin to phase out in 2021 (unless future legislation pushes it out even further).

    Interest rate state of play

    Figure 1 illustrates the history of the second segment rate; this rate often closely tracks to the overall effective rate of the three-segment yield curve and demonstrates how the mechanics of rate stabilization works. The chart shows the second segment rate from the two-year average yield curve and (starting in 2012) the 25-year average yield curve, as well as the corridor around that 25-year average.

    The bold red line shows the estimated effective rate sponsors actually used for determining their minimum funding liabilities. From 2008 through 2011, this rate was simply based on the two-year average rate, but in 2012 the effective rate jumped up to be 90% of the 25-year average — an increase of almost 2 percentage points. Since then, there have been small annual decreases of about 20 basis points in the effective rate as the relatively high interest rates of the 1990s are replaced by recent lower rates. These decreases in rates led to an increase in liabilities of 2% to 4% each year. While the increase is not desirable, it has been manageable, predictable and relatively consistent for much of the past decade.

    Starting in 2021, when the corridor is set to widen and the 25-year average continues to drop, the pace of change will pick up significantly. Assuming rates remain at February levels, there will be a decrease in the effective rate of about 1.1 percentage points over the next three years. This magnitude of a rate drop during the period will lead to liability increases of 15% to 25%.

    Effects

    Interest-rate stabilization has affected pension plans in two key areas: contributions and plan administration. Pension plan sponsors are required to contribute a seven-year amortization of any unfunded liabilities plus the annual cost of benefit accrual and plan expenses. Therefore, any big increases in unfunded liabilities will lead to a big increase in required contributions. Plans that have had relatively stable minimum required contributions using stabilized interest rates will likely see their contributions increase significantly once stabilization ends. Depending on the characteristics of a plan's funded status today, it could result in contribution levels more than doubling in the coming years. Even plans that have become accustomed to being overfunded using stabilized rates may find that they suddenly have shortfalls and required contributions.

    The second area that could affect pension plans is funded-status-related benefit restrictions. Pension plans whose adjusted funding target attainment percentage falls below 80% are restricted from paying certain types of benefits, the most common of these being lump-sum payments. Many plan sponsors find these benefit restrictions unacceptable and would rather contribute the necessary amount to avoid falling below the 80% threshold. With stabilized interest rates in effect, many sponsors have avoided the need to make these additional contributions, but that may change starting in 2021 when the stabilization starts to phase out.

    Conclusion

    When the Pension Protection Act was first passed in 2006, the intention was to get pension plans fully funded on a mark-to-market basis within seven years. Almost immediately, the financial crisis made this goal unattainable in the short term, and extremely low interest rates caused Congress to kick the can down the road even further via interest rate stabilization. However, barring further legislation, we will finally enter a seven-year full-funding regime, and sponsors that don't plan for it may find themselves with surprising cash requirements in the very near future. It is imperative for plan sponsors to understand the magnitude and timing of potential pension cash calls and to devise a strategy for dealing with them now.

    Joe Anzalone and Michael Clark are directors and consulting actuaries at River and Mercantile Solutions, New York and Denver, respectively. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.

    Related Articles
    Cash is back in the fold as returns rise
    Lowest quality bonds now make up majority of U.S. investment-grade debt
    Fed to keep rates steady for 'some time' – FOMC minutes
    U.S. corporate pension plan funding ratio drops in May – 2 reports
    Recommended for You
    John Bowman
    Commentary: Why, and how, our industry must renew its commitment to a fiduciary mindset
    Charles Millard
    Commentary: Public pension staff pay needs less politics
    Shuen Chan
    Commentary: Getting real in the journey to net-zero
    The Institutional Investor's Guide to ESG Investing
    Sponsored Content: The Institutional Investor's Guide to ESG Investing

    Reader Poll

    January 25, 2023
    SEE MORE POLLS >
    Sponsored
    White Papers
    Show Me the Income: Discovering plan sponsor and participant preferences for cr…
    The Future of Infrastructure: Building a Better Tomorrow
    Fulcrum Issues: Equity Returns and Inflation — Choose Your Own Adventure
    What Matters Most in Considering a Private Debt Strategy
    Why pursue direct lending in the core middle market?
    Research for Institutional Money Management
    View More
    Sponsored Content
    Partner Content
    The Industrialization of ESG Investment
    For institutional investors, ETFs can make meeting liquidity needs easier
    Gold: the most effective commodity investment
    2021 Investment Outlook | Investing Beyond the Pandemic: A Reset for Portfolios
    Ten ways retirement plan professionals add value to plan sponsors
    Gold: an efficient hedge
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today
    December 12, 2022 page one

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    130 E. Randolph St.
    Suite 3200
    Chicago, IL 60601

    Contact Us

    Careers at Crain

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Content Solutions
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    • Privacy Request
    Pensions & Investments
    Copyright © 1996-2023. Crain Communications, Inc. All Rights Reserved.
    • Topics
      • Alternatives
      • Consultants
      • Coronavirus
      • Courts
      • Defined Contribution
      • ESG
      • ETFs
      • Face to Face
      • Hedge Funds
      • Industry Voices
      • Investing
      • Money Management
      • Opinion
      • Partner Content
      • Pension Funds
      • Private Equity
      • Real Estate
      • Russia-Ukraine War
      • SECURE 2.0
      • Special Reports
      • White Papers
    • Rankings & Awards
      • 1,000 Largest Retirement Plans
      • Top-Performing Managers
      • Largest Money Managers
      • DC Money Managers
      • DC Record Keepers
      • Largest Hedge Fund Managers
      • World's Largest Retirement Funds
      • Best Places to Work in Money Management
      • Excellence & Innovation Awards
      • WPS Innovation Awards
      • Eddy Awards
    • ETFs
      • Latest ETF News
      • Fund Screener
      • Education Center
      • Equities
      • Fixed Income
      • Commodities
      • Actively Managed
      • Alternatives
      • ESG Rated
    • ESG
      • Latest ESG News
      • The Institutional Investor’s Guide to ESG Investing
      • ESG Sustainability - Gaining Momentum
      • Climate Change: The Inescapable Opportunity
      • Impact Investing
      • 2022 ESG Investing Conference
      • ESG Rated ETFs
    • Defined Contribution
      • Latest DC News
      • DC Money Manager Rankings
      • DC Record Keeper Rankings
      • Innovations in DC
      • Trends in DC: Focus on Retirement Income
      • 2022 Defined Contribution East Conference
      • 2022 DC Investment Lineup Conference
    • Searches & Hires
      • Latest Searches & Hires News
      • Searches & Hires Database
      • RFPs
    • Performance Data
      • P&I Research Center
      • Earnings Tracker
      • Endowment Returns Tracker
      • Corporate Pension Contribution Tracker
      • Pension Fund Returns Tracker
      • Pension Risk Transfer Database
      • Future of Investments Research Series
      • Charts & Infographics
      • Polls
    • Careers
    • Events
      • View All Conferences
      • View All Webinars
      • 2023 Defined Contribution East
      • 2023 ESG Investing