Commentary: 2023 corporate pension plans — looming surprises or opportunity for more improvement?

Most sponsors of corporate defined benefit plans were pleasantly surprised by improved funding levels on an accounting or economic basis in 2022, driven by significantly higher pension liability discount rates.

Unfortunately, many pension plan sponsors will be unpleasantly surprised by three issues in 2023:

• Higher reported pension expense.
• Higher cash contributions.
• High probability of reduced funding levels.

A key driver of all three is long-term interest rates.

While plan sponsors cannot control interest rates, they can take steps to control the impact that investment markets have on their financial reports, cash flow and balance sheet. Plan sponsors don't just have to live with these outcomes — proactive steps taken with the guidance of forward-thinking advisers can make a world of difference.

Defined benefit plans impact plan sponsor income statements through the calculation of net periodic pension cost (or NPPC). This calculation relies on management's chosen assumptions, such as the expected return on assets (or EROA) as well as on inputs like the pension liability discount rate (which is tied to yields on long-term bonds).

All else equal, if the discount rate increases and the expected return on assets is not adjusted upwards by a similar amount, then the net periodic pension cost will likely increase, directly reducing metrics such as net income, which will have a negative effect on a company's profitability.

A key to managing net periodic pension cost is to have the right tools and flexibility in the plan's asset allocation to provide room to put the expected return on assets where it needs to be, using a logical process that will be accepted by auditors.

An assumption-setting process can be created that ensures that issues such as increasing discount rates and other factors have a reduced impact on net periodic pension cost, such as making the expected return on assets partially dependent on the level of long-term interest rates using a "building block" approach to creating expected returns, which would directly reflect rises in risk-free yields as well as credit spreads.

A properly constructed investment portfolio can also preserve the expected return on assets even as pension plan investment risk is reduced, thereby maintaining pension-related net income much further into the derisking process than would generally be possible. Plan sponsors should know that they do not just have to accept the status quo in this area.

Most corporate pension plan sponsors have enjoyed several years where making pension contributions has been optional, providing welcome cash flow flexibility.

This flexibility was provided in large part by pension funding relief rules passed by Congress over the last decade. The key driver of relief is the use of liability discount rates to calculate minimum funding requirements that are smoothed and based on 25-year averages of rates and, until recently, much higher than the market-consistent liability discount rates used to calculate liability values on an accounting or economic basis. In 2022, market-based pension liability discount rates increased significantly, and are now close to the heavily smoothed/averaged rates used to calculated minimum funding amounts stipulated by the IRS. The IRS discount rates for 2023 funding valuations are 4.75% for cash flows within the first five years, 5% for cash flows within the next 15 years and 5.74% for cash flows over 20 years.

Regardless of how they were invested, most pension plans saw asset values fall significantly in 2022, especially if they had significant holdings of long-term bonds used to match liabilities.

For most plans, their market-based liability values fell by more than their assets, so deficits shown on balance sheets or calculated for economic purposes shrank.

However, the smoothed/averaged interest rates used to calculate liability values for funding purposes did not move as much, and so liability values on the IRS/minimum required funding basis moved very little. Falling asset values and stable liability values on this basis caused funding levels to drop precipitously. The combination of all of this is that many plan sponsors will be forced to resume minimum required contributions to their pension plans starting in the near future.

There are decisions that can be made now that could reduce (or in some cases, eliminate) such funding requirements, at least temporarily by changing the way in which their minimum funding pension liabilities are calculated.

In addition, there are steps that could be taken later in 2023 that could favorably remove pension liabilities altogether as well as reduce future funding requirements. Actuarial advisors should be raising these options with their clients and leave sufficient time to implement solutions. Waiting until late 2023 to start these discussions will be too late.

Due to the significant increase in long-term interest rates in 2022, and despite poor equity market returns, many corporate pension plan sponsors have seen meaningful funding level improvements.

While long-term interest rates may not reach the lows we saw in the midst of the pandemic anytime soon, rates can certainly go back down, especially if the economy slows significantly or goes into recession. Indeed, since peaking in October 2022, long-term rates are down 50 to 75 basis points, which translates into a 5% to 10% increase in the value of pension liabilities, thus reducing pension funding levels.

Plan sponsors can look to lock in some of their funding level gains by increasing allocations to long-term bonds. But there are other ways of locking in gains without also selling equities or other higher return assets to buy bonds.

Utilizing options on major equity indexes, for example, can help reduce risk while preserving the expected return on assets, while also reducing the risk of large increases in minimum funding requirements. Plan sponsors stuck in a world where their only option is to "sell equities/buy bonds" to derisk should know that there are sensible, practical alternatives to consider.

These alternatives aren't just available for jumbo plan sponsors (those with more than $1 billion in assets), but can be utilized for plan sponsors with medium- to large-sized plans as well.

The options available to plan sponsors largely involve the use of derivative instruments (e.g., options, swaptions) and can be accessed directly by the plan or indirectly through the use of levered funds.

While funding status through 2022 may have improved, there are potentially some unexpected outcomes in 2023 that pension plan sponsors will have to deal with. Most of these outcomes can be mitigated if plan sponsors take action earlier vs. later.

Discussing these options proactively can lead to positive results for both the plan and to the plan sponsor. The method of "set-and-forget" derisking glidepaths can lead to significant, unpleasant, surprises for sponsors. Avoiding surprises requires proactivity and customization. Once again, having a thoughtful plan for managing and derisking a pension plan can provide major benefits.

Ryan McGlothlin is a managing director at Agilis, based in Boston. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.