Most pension plans now measure liabilities using stabilized interest rates established under the Moving Ahead for Progress in the 21st Century Act (MAP-21). The stabilization temporarily reduces minimum required contributions to defined benefit plans. The corridors for setting these interest rates are scheduled to widen over time, with the stabilizing effect of MAP-21 likely abating as bond yields rise.

The Highway and Transportation Funding Act (the Act), which was signed into law by President Obama on August 8, will delay the widening of the corridors. This pension funding stabilization will increase the effective interest rates for liability valuations and reduce required contributions for plan years 2013 through 2017, according to our estimates.

This analysis projects actuarial funding obligations for single-employer plans with 1,000 or more participants under the Act. Plans were assumed to make minimum required contributions to cover normal costs and shortfall amortizations, and to use funding balances when applicable. Asset and liability dynamics of plans were individually simulated and reflect plan characteristics, regulatory and funding rules, and forward-looking assumptions of economic conditions. The appendix describes the model and assumptions in detail.

The Act will increase effective interest rates by about 30 to 130 basis points for 2013 through 2018 (see Figure A-4 in the appendix). After 2018, the 24-month smoothed segment rates are projected to fall within the corridors around the 25-year moving average rates. That is, the Act will no longer alter effective interest rates.

Pension liabilities were valued using either the spot bond yield curve or the 24-month smoothed segment rates.1 In the current low-interest-rate environment, the vast majority of plan sponsors opt for the smoothed segment rates because they reduce pension liabilities and funding obligations. Under MAP-21, segment rates that fall outside of certain ranges are replaced by “stabilized rates.” The boundaries are a corridor around a 25-year average of segment rates. The corridor starts at 10% for 2012, increasing by 5% each year until reaching plus or minus 30% for 2016 and later. The Act will extend the 10% corridors through 2017 and delay the widest 30% corridor until after 2020 (see specific corridors in the appendix, Figure A-5).

Under the Act, minimum required contributions will be reduced by about $69 billion for plan years 2013 to 2017, varying significantly by year (Figure 1). Although making smaller contributions could ease financial constraints on plan sponsors or enable them to deploy their capital elsewhere, the stabilization will reverse starting in 2018.

Figure 1. Estimated impact of the Act on minimum required contributions ($B)
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Notes: The estimates considered only calendar-year plans with 1,000+ participants. Form 5500 historical data show that plans often made significantly higher contributions than the required minimum.
Source: Towers Watson

Between plan years 2013 and 2021, total minimum required contributions will increase by about $32 billion under the Act, according to our estimates. This reflects both the elimination of stabilization and the reduced capital accumulation in the pension plan resulting from lower contributions. Historically, pension plan sponsors have often contributed significantly more than the required minimum. For instance, our sample of single-employer plans contributed roughly $74 billion for 2012 — $39 billion more than the required $35 billion (based on the latest Form 5500 data). The actual impact of the extension of pension interest rate smoothing is sensitive to these additional contributions.

Our modeling and projections incorporated a gradual normalization process for interest rates. To test sensitivity of results, we alternatively considered a faster pace — a further 50-basis-point rise in spot interest rates relative to the baseline by the end of 2015. Under this scenario, the Act would still reduce pension plan funding obligations but by a smaller margin: an estimated $56 billion reduction through the 2017 plan year compared with $69 billion in the baseline.

When we slowed the pace of interest rate normalization — 50 basis points short of the mean projections by year-end 2015 — our projections showed the Act would have a larger effect: an estimated total decrease of $75 billion through 2017 versus $69 billion.2 The key inference is that the Act’s impact will be weaker in an environment of faster-rising interest rates, because the general 24-month smoothed segment rates will more quickly supersede the 25-year average corridors. On the contrary, if the low interest rates persist, the extension of corridors under the Act will ease funding obligations more significantly.

Appendix: Model, data and assumptions

Our model incorporated the main provisions of the Pension Protection Act (PPA); the Worker, Retiree and Employer Recovery Act of 2008 (WRERA); the 2010 Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act (Relief Act); various IRS regulations; MAP-21; and the Act. The PPA established the general seven-year schedule for funding shortfall amortization. The WRERA clarified and liberalized the use of smoothed asset values. The Relief Act allowed elections of a “2+7” or 15-year rule for funding the shortfall amortization. IRS guidance and regulations allowed re-elections of asset and liability valuation methods for certain years. MAP-21 provided for the use of “stabilized rates” for pension liability valuations. That is, the applicable rates may be necessarily adjusted so they fall within the 25-year averages of segment rates plus or minus corridors. The Act will delay the widening of the corridors under MAP-21, thus extending the contribution stabilization.

Form 5500 showed whether pension plans elected funding relief under the Relief Act. The election was either the 2+7 or the 15-year funding relief for any two funding shortfall years from 2009 to 2011. The majority of plans did without the relief. Among the minority who used it (about 13%), more plans elected the 15-year relief and applied it to 2010 and 2011 shortfalls.

The model considered the peculiar role of funding balances, including funding standard carryover balances (FSCBs, which are balances accumulated before 2008) and prefunding balances (PFBs, which are balances accumulated after 2008). According to the rules, funding balances can be applied to minimum required contributions, with FSCB applied first. In order to use a funding balance, plan funding for the previous year must have been 80% or higher. This funding ratio is measured as plan assets minus PFB divided by plan liabilities, not considering FSCB. We assumed that plans meeting these conditions use balances to offset the minimum requirement before contributing cash, and they will not accumulate additional funding balances (except through investment returns on existing balances).

The model simulated plans of various funded ratios, asset allocations, valuation methods and status (active versus frozen), as measured from Form 5500 data files. Growth of normal cost and payout rates were estimated and were assumed to vary in the model based on the plan’s active or frozen status. We also utilized estimated liability durations to reflect the sensitivity of liabilities to changes in interest rates.

Depending on the plan sponsor’s election, pension assets were measured at fair market or smoothed value. The latter was computed as the average value of three year-end market values in the model. Smoothed value included expected future investment earnings (at no more than a specified interest rate, presumably the third segment rate) and was constrained by the legal requirement that such smoothed value fall between 90% and 110% of market value. Pension liabilities were valued using smoothed segment rates (approximated by the effective interest rate in the model, calculated as the weighted average of three underlying segment rates).

The analysis made certain economic and financial assumptions, as reported in Figures A-1 and A-2.

  1. Plans disclose their asset allocations (percentages of total assets) in Form 5500 in categories of stock, investment-grade debt, high-yield debt, real estate and other. Index returns were used to approximate results in each category. We assumed that 67% of equity investment is in U.S. large cap (proxied by the S&P 500), 16.5% in small/medium cap (proxied by the Russell 2500) and 16.5% in international equity (proxied by the MSCI EAFE).

    Investment-grade and high-yield debt was assumed to be 100% in U.S. Barclays Aggregate bond index if debt duration was zero to six years, 67% in U.S. Barclays Aggregate and 33% in Barclays Long Government/Credit if debt duration was six to nine years, 33% in U.S. Barclays Aggregate and 67% in Barclays Long Government/Credit if debt duration was nine to 12 years and 100% in Barclays Long Government/Credit if debt duration was more than 12 years. Real estate was proxied by the NCREIF index, and other was proxied by the Global Hedge Fund Research Index.
  2. For the January 1, 2015, valuation, calendar year-end 2014 asset returns were assumed to equal those as of June 30, 2014, plus one-half the expected 2014 returns that were projected by Towers Watson Investment Services (TWIS).
  3. Historical interest rates are from IRS publications as of June 2014. For future rates, the effective interest rate was modeled by blending high-quality corporate yields, subject to the 25-year averages plus/minus the corridors in the spirit of MAP-21, or alternatively under the Act.3   
  4. Future yield rates and asset returns were projected based on capital market simulations provided by TWIS, based on July 2014 forward-looking assumptions.

Figure A-1. Baseline assumptions of investment returns (%)
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Source: Towers Watson

Figure A-2. Baseline assumptions of interest rates (%) under MAP-21
Pension Funding Stabilization: Estimated Impact of Extending Interest Rate Corridors

Note: Effective interest rates were calculated as the weighted average of three underlying segment rates.
Source: Towers Watson

Figure A-3. Estimated aggregate costs and contributions ($B) under MAP-21
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Notes: The estimates considered only calendar-year plans with 1,000+ participants. Discretionary contributions are additional funds needed to reach 80% funding. These amounts were not presumed to be paid in the model projections but are reported here to (partially) indicate extra contributions many plan sponsors could choose to make for a variety of reasons.
Source: Towers Watson

Figure A-4. Estimated effective interest rates (%) for active pension plans
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Note: Effective interest rates were calculated as the weighted average of three underlying segment rates.
Source: Towers Watson

Figure A-5. Corridors around 25-year average of corporate bond interest rates (%)
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Source: MAP-21 and the Highway and Transportation Funding Act of 2014


Endnotes

1. Three segment rates were used to determine present values of pension benefits with varying maturities, which were based on a 24-month average of high-quality corporate bond rates as prescribed by the IRS.

2. Bond returns in 2015 are assumed to have a one-off gain or loss due to these interest rate changes, as estimated by applying approximate durations.

3. There may be a difference between our projected rates and the official rates to be published by the IRS.