The largest factor driving up liabilities during 2017 was a decline in the discount rate used to determine the present value of the liabilities. (The pension plan discount rate is based on AA, long-duration corporate bond yields.) The impact of the lower discount rate, when combined with other items such as benefit accruals, benefit payments, and other assumption changes, resulted in an aggregate liability increase in 2017.

On the other side of the pension plan ledger, assets also grew, driven by double-digit investment returns and employer contributions. Investment returns were strong for both equities and fixed income. The average plan return of 13 percent was well above the expectation of 7 percent. In addition, employers' contributions to their plans was up roughly 20 percent in 2017 compared with 2016, possibly in response to rising premiums from the Pension Benefit Guaranty Corporation (PBGC). Another driver might have been a desire to accelerate plan funding for tax purposes; a contribution made now, under the old tax regime, carries a larger tax deduction than a contribution made later, under the new tax regime. Bottom line: The asset increase outpaced the corresponding liability increase, leading to the aggregate funded status improvement.

What Does This Mean for Pension Plan Management?

A prudent first step would be to update your evaluation of your plan's funded status risk. This is generally defined as the risk of an unexpected and extreme decline in funded status. An improvement in funded status during 2017 might result in either lower or higher funded status risk. Which way it goes depends on several factors, of which the most significant is the plan's asset allocation. You should evaluate any change in funded status risk in terms of its effect on the plan's objectives and its relation to the risk appetite of both the pension plan and the company overall.

The simplest way to measure funded status risk is to project the funded status one year out under a baseline set of assumptions that are consistent with the plan's valuation assumptions. For example, you might assume interest rates won't change and asset returns will remain the same as expected. Next, calculate a separate one-year forecast that's based on negative capital market assumptions. For example, assume a 100 basis point decline in interest rates and a 20 percent loss in equity values.

Then compare the two end-of-year funded-status results. The difference in projected funded status is the plan's funded-status risk. You can perform the same exercise with more precision by using a statistical model to identify the tail scenario that has a 5 percent probability.

The evaluation of funded-status risk might suggest that the plan sponsor take certain actions to move the plan closer to its long-term objectives. Most plan sponsors have financial objectives that drive the management policies of the plan, objectives such as “get fully funded” or “reduce plan volatility.” Achieving such a funded-status objective involves trade-offs between risk, time, and cash. A plan sponsor is always balancing:

• Risk: How much investment risk are you willing to bear?
• Time: How long is your time horizon?
• Cash: What are your constraints for contributions?

When the plan's funded status improves, it might make sense to adjust the plan's strategic asset allocation because its risk posture has changed, or possibly in response to a previously established de-risking glide path. The new tax bill—and, more specifically, its impact on deductions and after-tax costs—might also affect a company's interest in accelerating contributions. Both of these trends mean 2018 may be the year for your plan to execute on a settlement strategy such as purchasing a retiree annuity.

Plan sponsors have multiple strategy levers they may deploy in managing pension plan risk, including:

• Asset allocation—Shift between return-seeking assets and liability-hedging assets.
• Contributions—Plan for the minimum required, or accelerate by making discretionary contributions.
• Design—Change the benefit formula (e.g., close to new entrants, freeze accruals).
• Settlement—Transfer assets and liabilities, along with the associated funded-status risk, to another party through a lump sum or annuity purchase.

It is important to note that these strategies are interrelated. Therefore, plan sponsors need to manage them collectively, rather than considering each in isolation.

|

The Time Is Right to Re-evaluate

Any solution for managing pension plan funded-status risk should be considered as part of a comprehensive strategy that starts with an updated risk assessment and then considers all the multiple strategic levers that can be pulled upon by the plan sponsor to move toward the ultimate objective.

The first quarter of 2018 greeted us with discount rates increasing almost 50 basis points, creating liability gains, as equity prices became more volatile. Some pension plans may have seen a small improvement in funded status so far this year, while others are undoubtedly experiencing losses after the 2017 gains. Either way, now's the time to assess your plan for possible modifications to plan management strategy.

If I were on a pension plan committee, I would take this opportunity to re-evaluate the plan's risk and establish a holistic plan to manage toward its financial objectives—and these steps might result in some strategy changes for 2018.

Gordon A. Young, FSA, MAAA, FCA, EA, is a senior retirement consultant in the Milwaukee office of Willis Towers Watson. Young has 27 years of experience helping clients manage their retirement programs. He is a credentialed member of the Society of Actuaries, the American Academy of Actuaries, and the Conference of Consulting Actuaries, and he earned a bachelor's degree in economics from Yale University.