Pension stabilization in the recently passed highway bill — more formally known as the Moving Ahead for Progress in the 21st Century Act (MAP-21) — will reduce required contributions for single-employer pension plans substantially, especially for plan years 2012 and 2013. Unless interest rates rise, however, required contributions will return to pre-MAP-21 levels in a few years.

MAP-21 allows plan sponsors to measure pension liability using the 25-year average of segment rates plus or minus a corridor. The corridor starts at plus or minus 10% for 2012, increasing by 5% each year until it reaches plus or minus 30% for 2016 and later. According to our estimates, this will increase segment interest rates by 100 – 320 basis points, which will significantly lower plan liabilities and thus required contributions for plan years 2012 to 2016. Over time, the pension funding stabilization effect will decline as projected segment rates fall within the corridors.

Funding stabilization under MAP-21

Before MAP-21, minimum required pension contributions were projected to nearly double between plan years 2011 and 2013 — rising from $39.7 billion to $71.7 billion.1 Had interest rates continued to decline, the funding obligation for 2015 would have reached $105.8 billion (Figure 1).

Figure 1. Measured regulatory funded status and required minimum contributions

 

Before MAP-21

Under MAP-21

Plan year

Funded status (%)

Minimum required contributions ($B)

Funded status (%)

Minimum required contributions ($B)

1/1/2009

90.0

88.9*

90.0

88.9*

1/1/2010

94.0

96.1*

94.0

96.1*

1/1/2011

99.9

39.7

99.9

39.7

1/1/2012

97.0

54.2

114.5

2.0

1/1/2013

94.4

71.7

105.9

16.7

1/1/2014

90.7

92.1

99.6

51.8

1/1/2015

88.9

105.8

94.2

79.5

1/2/2016

90.9

100.8

90.5

95.4

* Estimates of actual contributions are based on Form 5500 and financial statement data.
Source: Towers Watson

Instead, under MAP-21, aggregate pension funding obligations should be substantially lower. For plan year 2012, for example, aggregate minimum required contributions are projected at $2.0 billion with MAP-21 versus $54.2 billion without it. As published by the Internal Revenue Service (IRS) (Notice 2012-55), segment rates for 2012 are 120 – 348 basis points higher (see Appendix). Higher first and second segment rates increase the amortization payment of the pension funding shortfall, but the shortfall amortization basis shrinks sharply with higher interest rates. As shown in Figure 1, many plans will go over 100% funded and thus eliminate their amortization basis.

The reduction in required contributions is expected to start to ebb in 2014 because the 24-month smoothed segment rates and 25-year corridors are likely to converge. If interest rates remain low, contributions will climb back up to pre-MAP-21 levels.

Lower pension plan contributions generally imply lower funded levels for the future. Plan sponsors need to carefully consider their own forecast of interest rates and whether contributing much less for the next few years is in their long-term best interest.

Updates in data and assumptions

This analysis starts with equity and bond market conditions as of June 30, 2012. For pension liability valuations, we use the smoothed segment rates and the composite corporate bond rate (CCBR) published by the IRS. Looking forward, we use Towers Watson Investment Services (TWIS) July 2012 projections of asset returns and high-quality corporate bond yields. Figure A-1 in the Appendix lists the financial and economic assumptions without consideration of MAP-21, and Figure A-2 lists the segment rates under MAP-21. The 25-year average segment rates, with or without corridors, are significantly higher than the current segment rates. Over time, the differences shrink as the currently low interest rates work their way into the 25-year averages.

We have also modified several important assumptions from earlier published analyses of projected funding obligations, based on newly available data and changing economic and plan conditions.2 We assume benefit accrual at 3.0% of liabilities for non-frozen plans (which include both active and closed plans), compared with 5% in the past. The benefit payout rate is assumed to be 7.0% of liabilities for non-frozen plans and 7.5% for frozen plans (versus 4% for all plans in the past).3 The duration of liabilities is assumed to be 12.5 years (instead of 14 years) for non-frozen plans and 9.5 years (instead of nine years) for frozen plans. We used the September segment rates (highest among the last four months of the year), as practiced by many plans and permitted by current regulations. This last change means segment rates are 5 – 100 basis points higher for plan years 2009 to 2012, bringing plan obligations significantly lower than previously measured by December rates.

The model includes funding relief offered under the 2010 Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act (Relief Act). Only 6% of plans are assumed to take advantage of the “2+7” or the 15-year funding relief for any two of the funding shortfall years of 2009 to 2011, based on Pension Benefit Guaranty Corporation statistics. The model incorporates the distribution of relief methods taken by plans and applies the corresponding weights to the results.

Appendix

Our model incorporates the main provisions of the Pension Protection Act (PPA); the Worker, Retiree and Employer Recovery Act of 2008 (WRERA); the Relief Act; various IRS regulations; and Map-21. The PPA establishes the general seven-year schedule for funding shortfall amortization. The WRERA clarifies and improves the use of smoothed asset values. The Relief Act allows elections of the 2+7 rule or the 15-year rule for funding shortfall amortization. The IRS guidance and regulations allow re-elections of asset and liability valuation methods for certain years. MAP-21 provides for the use of 25-year averages of segment rates plus or minus corridors for pension liability valuations.

The model simulates plans of various initial funded statuses, asset allocations, valuation methods and non-frozen statuses. Weights are applied to these plans to reflect their empirical distributions, as calculated from Form 5500 data files.

Depending on the plan sponsor’s election, pension assets are measured at fair market value or smoothed value. The latter is computed as the average value of three year-end market values in the model. Smoothed value includes expected future investment earnings (at no more than a specified interest rate, the third segment rate) and is constrained by the legal requirement that such smoothed value fall between 90% and 110% of market value. Pension liabilities are valued using either the spot bond yield curve (in actuality, a one-month average, approximated by the CCBR in the model) or the smoothed segment rates (approximated by the effective interest rate in the model, calculated as the weighted average of the three segment rates). These rates are published by the IRS.

The analysis makes certain economic and financial assumptions. Figure A-1 outlines the assumptions for simulating pension funding obligations before MAP-21 was passed. Figure A-2 gives the estimated increases in segment rates for plan years 2013 to 2016 under MAP-21. The segment rates for plan year 2012 (end of calendar year 2011) are those 25-year average rates minus the 10% corridor that were officially published by the IRS.4

  1. End-2012 asset returns and interest rates are assumed to equal those as of June 30, 2012.
  2. For 2013 to 2016, CCBRs are set equal to 10-year high-quality corporate bond yields; segment rates in the table are averages of spot segment rates in the preceding 24 months; spot first segment rates are equal to five-year high-quality corporate bond yields; spot second segment rates are equal to the average of 10-year and 20-year high-quality corporate bond yields; and spot third segment rates are equal to 20-year high-quality corporate bond yields. These yields are projected by TWIS, based on July 2012 assumptions.
  3. Historical equity and bond returns are based on Russell 3000 equity and Barclays Capital Long Government/Credit Bond Indexes, respectively. Annual equity and bond returns for 2013 to 2016 are based on the forward-looking TWIS projections.

Figure A-1. Economic and financial assumptions (calendar year-end, %)

 

2009

2010

2011

2012

2013

2014

2015

Equity return

28.34

16.93

1.03

9.32

8.90

8.55

8.31

Bond return

1.92

10.16

22.49

5.04

2.56

0.85

1.54

CCBR

5.88

5.60

4.71

4.27

2.83

3.43

3.89

1st segment rate

5.03

3.78

2.06

1.78

1.70

1.83

2.35

2nd segment rate

6.73

6.31

5.25

4.67

4.14

3.75

3.71

3rd segment rate

6.82

6.57

6.32

5.77

5.02

4.46

4.20

Source: Towers Watson

Figure A-2. Estimated increases in interest rates under MAP-21 (calendar year-end, %)

 

2009

2010

2011

2012

2013

2014

2015

1st segment rate

   

5.54

4.72

4.25

3.80

3.36

2nd segment rate

   

6.85

6.09

5.58

5.06

4.56

3rd segment rate

   

7.52

6.78

6.22

5.65

5.11

Increase in segment rates under MAP-21

         

1st segment rate

   

3.48

2.94

2.55

1.97

1.01

2nd segment rate

   

1.60

1.42

1.44

1.31

0.85

3rd segment rate

   

1.20

1.01

1.20

1.19

0.91

Source: Towers Watson


Endnotes

1 Historically, many sponsors contribute more than the minimum required.

2 The series of prior studies on pension plan funding obligations appears in the January, April, June, October and November 2009, March and July 2010, April and September 2011, and March 2012 issues of Towers Watson Insider.

3 Using previous accrual and payout rates, with new economic conditions, would lead to higher aggregate minimum required contributions by $57 billion to $98 billion a year over 2012 to 2016.

4 There is some difference between our estimates and the IRS rates. They are methodologically similar (a regression approach) but data-wise different. The IRS’s 25-year average segment rates for 2012 would be 20 – 30 basis points lower if our estimates were used.

Contact:

Gaobo Pang
+1 703 258 7401
gaobo.pang@towerswatson.com