On March 11th, President Biden signed into law the American Rescue Plan Act (ARPA) providing COVID-19 related relief to many sectors. ARPA contains provisions giving funding relief to single employer defined benefit pension plans, primarily by letting plan sponsors continue to use discount rates (i.e., corporate bond yields) materially higher than current market yields when determining their annual minimum required pension contributions.
Three times over the past decade, in 2012, 2014 and 2015, Congress provided contribution relief by allowing sponsors to use “stabilized” higher-than-market discount rates reflecting a corridor that effectively set a minimum rate based on the 25-year average of historical bond yields.
Much of the existing funding relief was set to begin phasing out this year, but ARPA kicks the can down the road to the end of this decade, tightening the corridor around discount rates tied to the 25-year average and setting an explicit floor on those rates. ARPA also grants permanent relief by lengthening the period over which gains and losses have to be amortized.
While some plan sponsors have—and will continue to—base contributions on objectives that are largely independent of minimum funding rules, we believe that many sponsors will want to understand the impact of these changes on future contributions, P&L expense, PBGC premiums and benefit restrictions. Plan sponsors will likely want to see if contributing the minimum required amount meets their specific objectives, risk tolerances and budgets or if another funding policy would work better. To avoid unwanted surprises, careful analysis is highly recommended. Projections such as asset/liability modeling studies can be very helpful in that regard.
Impact on liability driven investment (LDI) strategies
Many plan sponsors have adopted LDI strategies to lessen interest rate risk and reduce funded status volatility. However, ARPA helps mitigate interest rate risk for cash funding purposes over the next few years because stabilized discount rates are far removed from market yields and have a floor. In essence, this drops the liability duration very low for funding purposes – rates would have to rise dramatically to have an impact on funding liabilities. So, should plan sponsors lower the duration of their fixed income investments too?
A few items to consider:
The underlying economics haven’t changed—participants are still owed the same amount, and the market value of that obligation does not change. ARPA does not change the benefits participants will receive; it only affects the timing of when minimum required contributions are due. Therefore, the reasons for employing an LDI strategy still hold.
Lowering the asset duration (decreasing the interest rate hedging) will increase volatility of other funded status measures for a plan using an LDI strategy because the asset/liability match will lessen. Since ARPA doesn’t change the discount rates used to determine PBGC variable rate premiums, the plan is more likely to be faced with PBGC premium volatility. And if sponsors make lower contributions than they would have without ARPA’s relief, their plans will be less well-funded and their PBGC premiums will also rise.
ARPA does not affect US GAAP reporting. For accounting purposes, liabilities will still be determined using market-based corporate AA bond yields and assets measured at market values, resulting in increased funded status volatility if asset duration is shortened. So, for example, LDI will continue to help manage balance sheet and P&L volatility.
While interest rates have recently ticked up, the rate environment is still low by historical standards. Asset managers could lower duration if they take a tactical view that rates will rise by more than what the market has priced. ARPA provides short-term downside protection against increased cash contributions should that view be incorrect. In a situation where cash contributions are prioritized above PBGC variable rate premiums and accounting costs and volatility, sponsors may give this tactical view more consideration. However, eventually contributions will come due, as this is in large part a “pay now or pay later” issue.
Consider increasing the allocation to risk-seeking assets
Some plan sponsors may consider increasing their allocation to risk-seeking assets, perhaps sponsors faced with a deficit and/or those not wanting to divert cash to the pension plan now. ARPA’s funding relief provides short-term downside protection against cash contribution requirements due to continued low or declining rates. ARPA also allows a longer amortization period to pay off unfunded amounts, so risk-taking may be worthwhile. These additional “smoothing” mechanisms could support an increase in risk-seeking assets (which may accompany a decrease in LDI assets), but there are potential concerns:
An asset/liability study would provide the framework to discuss the risk/reward tradeoffs of various strategies.
Funding policies to consider
Although ARPA provides for potential deferral of contributions, some plan sponsors may want to continue funding ignoring the relief or even accelerate funding to meet other goals. There are myriad factors to consider when designing an appropriate funding policy, including, but not limited to the following:
The new law provides welcome relief to many individuals and businesses who have suffered as a consequence of the pandemic. Pension plan sponsors will need to examine the impact of the relief — carefully balancing the advantages of pushing contributions into the future with the desirability of avoiding large contribution surprises down the road, while factoring in competing cash needs of the business. The funding rules are complex and many interacting factors come into play when determining the most advantageous funding and investment strategies. Mercer has experts in the integrated funding and investments decision-making framework, and we would be happy to help you: