Hedge both accounting and funding liabilities

Many corporate pension plan sponsors have enjoyed a “contribution holiday”¹ due to the long-term average discount rates allowed by the Internal Revenue Service (IRS) to value funding liabilities used for minimum required contribution calculations². However, plan sponsors are again facing contribution volatility as many plans’ PPA funded status fell in 2022, given plan assets dropped³ but PPA funding liabilities remained stable⁴. Given the sharp increase in bond yields over the last year, current discount rates have converged with the long-term average yields⁵ used for PPA funding calculations. Therefore, corporate pension plan sponsors may have a unique opportunity in 2023 to begin hedging both Accounting and Funding liabilities by electing to use the IRS full yield curve to discount their funding liabilities going forward.

Pension plan regulations

Corporations are subject to various rules and regulations to value their pension obligations resulting in disparate present values of pension benefits. For example, there is one set of assumptions for valuing liabilities for accounting purposes under US GAAP for corporate balance sheets, while another set of assumptions is used for valuing liabilities under ERISA and PPA⁶ for minimum funding purposes, and yet another for PBGC⁷ premium calculations.

Many corporate plan sponsors employ Liability Driven Investing (LDI) to hedge the interest rate risk of their plan’s accounting liability. The main concept is based on the fact that corporate pension accounting liabilities are marked-to-market based on high quality corporate bond yields⁸. By investing in similar-duration assets, the plan’s liabilities and assets could move in tandem as interest rates change, thus reducing the volatility on corporate balance sheets. However, because funding liability valuations employ interest rate smoothing, these liabilities are “unhedged” with the volatility around minimum required contributions remaining. Why is that the case?

In oversimplified terms, the rates that have been used by most corporate pension plans to discount funding liabilities are averaged over 24 months and, for the last decade, constrained by a 25-year average of bond yields⁹. Given this long-term average constraint, these yields for discounting funding liabilities have been relatively stable from year to year, and well above the current market rate for bond yields for many years¹⁰. The result has been lower liabilities and higher funded status for PPA contribution calculations compared with the corresponding accounting basis for many plans. 

With this “pension funding relief”, many pension plans had a PPA funded status over 100% (and corresponding accounting funded status below 100%) for many years¹¹, and therefore have had a contribution holiday for those years. Concurrently, some plan sponsors have been implementing LDI strategies in the pension trust’s asset portfolio seeking to reduce the volatility of unfunded pension debt on their corporate balance sheets. This combined strategy worked well for many years… until 2022.

Recent moves in 2022

Figure 1: Global equities vs. global bonds, annual returns, 1977-2022

In 2022 we saw the Federal Reserve raise interest rates 4.5%, and we also saw negative returns across many markets. As shown in Figure 1, global equities fell around 20% while global bonds fell around 14%, significantly reducing the asset portfolios of many pension plans. But, with the sharp increase in interest rates, liability values also fell creating very little movement in funded status … on an accounting basis. See Figure 2 as an illustrative example. However, on the PPA funding side, due to the stable discount rates utilized, there was no subsequent liability drop in the PPA funding liabilities. The result was a double-digit drop in funded status for many corporate pension plans on a PPA funding basis.

Figure 2a: A sample plan is illustrated below. In 2022, PPA liabilities for plans using the PPA stabilized segment rates were largely static, but marked-to market accounting liabilities fell sharply with rising rates along with many plans’ asset values.

Figure 2b: For this sample plan, the PPA funded ratio fell to be more in line with PBO funded ratio as of 12/31/22.

Therefore, the contribution holiday that many plan sponsors have enjoyed for much of the last decade may have now disappeared. As a result, contribution volatility may now be at the forefront of many plan sponsors and CFO’s conversations. But there may be an alternative option.

Discount curve methodology

As mentioned previously, interest rates have increased significantly in 2022 and as a result, the discount rates many plans use for accounting (marked-to-market) and funding (25-year average corridor) have converged, as seen in Figure 3. For those plans that may be using the 24-month average without the corridor for either supplemental funding or PBGC purposes, note that these rates are now lower than the alternative curves.

Figure 3a: Market yield curves use for discount rates have increased and converged with PPA smoothed discount rates

Pension Yield Curves as of December 31, 2022

Figure 3b:

Pension Yield Curves as of December 31, 2021

Even though for many years many plan sponsors have been taking advantage of the pension funding relief provided to employ a higher discount rate for funding liabilities, they have always had a choice. IRC Section 430 (h)(2)(D)(ii) allows plan sponsors the option to use the segmented rates with the 25-year average corridor, as discussed above, or use a one-month average full yield curve published by the IRS monthly. Given the convergence in rates, changing from the smoothed discount rates to the market-based full yield curve could have a minor effect on the funded status of the plan on a PPA basis. But the key is that now, the funding liabilities and accounting liabilities can both be managed through LDI. Note that plan sponsors may likely also want to change the asset smoothing method to Market Value for PPA funded status calculations.

Comparing the discount curves

There may likely be some basis risk as the two discount curves for accounting and funding will not be exactly the same, but they will both be market based. The accounting discount curve varies between plans, but is marked to market as of the date of the valuation and based on AA-rated corporate bond yields. The PPA funding target full yield curve is published by the IRS on a monthly basis and is an average of A-AAA quality corporate bond yields throughout the month.

Conclusion

For plans with certain plan years such as January 1, the year 2023 provides a unique opportunity for plan sponsors to take advantage of the recent rise in yields and the convergence of mandated discount rates for accounting and funding liabilities. They can opt to change their PPA funding target discount rate methodology and be able to hedge both PPA funding target and accounting liability measures, thus seeking to reduce volatility on both their balance sheet and budgeted cashflow. 

The concept of LDI is to help reduce volatility in funded status for marked to market liabilities by matching the duration of the plan’s liabilities with that of the plan’s assets. The hedging methodologies that are used today are more fine-tuned than they were a decade ago, and many plans already employ this strategy in seeking to reduce accounting funded status volatility. Given the unique rate environment, plan sponsors and CFO’s can have both PPA funding, PBGC liabilities, and accounting liabilities hedged by the same LDI-focused asset allocation¹². We encourage plan sponsors to discuss this potential assumption change with their plan actuaries to explore whether it is right for their plans. If they choose to make this assumption change, BLK is well-versed to help develop hedging solutions for both funding and accounting liabilities and we welcome the opportunity to partner with plan sponsors.